Global Financial Stability Report: Moving from Liquidity- to ... - IMF

World Economic and Financial Surveys

Global Financial Stability Report Moving from Liquidity- to Growth-Driven Markets

April 2014

International Monetary Fund

©2014 International Monetary Fund

Cataloging-in-Publication Data Joint Bank-Fund Library Global financial stability report – Washington, DC : International Monetary Fund, 2002– v. ; cm. – (World economic and financial surveys, 0258-7440) Semiannual Some issues also have thematic titles. ISSN 1729-701X 1. Capital market — Development countries — Periodicals. 2. International finance — Periodicals. 3. Economic stabilization — Periodicals. I. International Monetary Fund. II. Series: World economic and financial surveys. HG4523.G563

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Disclaimer: The analysis and policy considerations expressed in this publication are those of the IMF staff and do not represent official IMF policy or the views of the IMF Executive Directors or their national authorities. Recommended citation: International Monetary Fund, Global Financial Stability Report—Moving from Liquidity- to Growth-Driven Markets (Washington, April 2014).

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CONTENTS

Assumptions and Conventions

viii

Preface ix Executive Summary

xi

Chapter 1 Making the Transition from Liquidity- to Growth-Driven Markets

1

Financial Stability Overview Normalizing U.S. Monetary Policy—A “Goldilocks” Exit? Box 1.1. Deleveraging Trends in Selected Advanced Economies Box 1.2. Is the Japanese Financial System Rebalancing, and What Are the Financial Stability Implications? Box 1.3 Recent Periods of Turbulence in Emerging Market Economies Emerging Markets: External Risks and Transition Challenges Box 1.4. Macroprudential Policy in the United States Improving Euro Area Bank Asset Quality to Support Credit Box 1.5. Financial Regulatory Reform: Can We Make It to the Finish Line? Box 1.6. Rollout of Banking Union Is Progressing, but Challenges Remain Box 1.7. European Union Bank Deleveraging Annex 1.1. Constructing Term Premium Estimates for Major Advanced Economies Annex 1.2. Emerging Market Corporate Sensitivity Analysis Annex 1.3. Exploring the Relationship between Bank Capital Buffers, Credit, and Asset Quality References Chapter 2 How Do Changes in the Investor Base and Financial Deepening Affect Emerging Market Economies? Summary Introduction Box 2.1. A Primer on Mutual Funds Evolving Emerging Market Assets and Their Investor Bases Box 2.2: Financial Deepening in Emerging Markets Identifying the Financial Stability Effects of Changes in the Investor Base and in Local Financial Systems Box 2.3: Investment Strategies of Institutional Investors Box 2.4: Are Investors Differentiating among Emerging Markets during Stress Episodes? Box 2.5. Measuring Herding Policy Implications and Conclusions Annex 2.1: Data, Main Empirical Framework, and Additional Analyses References Chapter 3 How Big Is the Implicit Subsidy for Banks Considered Too Important To Fail? Summary Introduction

1 2 4 7 10 20 21 39 42 44 46 54 57 61 64 67 67 68 70 71 75 76 77 82 83 91 97 101 101 102

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GLOBAL FINANCIAL STABILIT Y REPORT: MOVING FROM LIQUIDIT Y- TO GROWTH-DRIVEN MARKETS

Is the Too-Important-to-Fail Problem Growing? Estimating Subsidy Values Box 3.1. Cross-Border Banking Linkages Box 3.2. Benefits and Risks of Large Banks Box 3.3. Estimating Implicit Too-Important-to-Fail Subsidies The Effects of Specific Reforms Policy Discussion Box 3.4. Banks and Sovereign Linkages Box 3.5. Recent Policy Initiatives Addressing the Too-Important-to-Fail Issue Box 3.6. Higher Loss Absorbency for Systemically Important Banks in Australia Annex 3.1. The Contingent Claims Analysis Approach Annex 3.2. The Ratings-Based Approach References

104 104 107 110 117 118 119 120 123 126 127 129 131

Glossary 133 Annex: IMF Executive Board Discussion Summary

141

Statistical Appendix

143

Tables 1.1.1. Indebtedness and Leverage in Selected Advanced Economies 1.1.2. Reduction in Gross Debt Levels in Selected Advanced Economies from the 2009–13 Peak 1.1. Issuance Trends for U.S. High-Yield Bonds and Loans 1.2. Change in 10-Year Government Bond Yields 1.3. Correlation and Beta between the U.S. Term Premium in the United States and other Major Advanced Economies 1.4. Debt, Leverage, and Credit in Selected Emerging Market Economies 1.5. Change in Gross Debt Levels in Selected Emerging Market Economies 1.6. Summary of Indicators 1.7.1. Large European Union Bank Deleveraging 1.7. Yield Curve Data Sources 1.8. Correlation of Term Premium Estimates 1.9. Sensitivity to the U.S. Term Premium 1.10. Granger Causality 1.11. Coverage of Firms by S&P Capital IQ 1.12. Credit Variables Used in the Vector Autoregression Exercise 2.1.1. Key Fund Characteristics 2.1.2. Shares of Types of Mutual Funds 2.3.1. Investment Constraints of Institutional Investors 2.1. Size of Global and Local Institutional Investors and Mutual Funds 2.2. Role of Financial Deepening in Dampening the Impact of Global Financial Shocks on Asset Prices 2.3. Summary of Methods and Results 2.4. Sample Economies 2.5. Definition of Variables Used in Estimations 2.6. Local Macroeconomic Factors and Global Financial Shocks— The Effect on Asset Prices and Portfolio Flows 3.1. Summary of the Estimates of Implicit Subsidies 3.2. Event Study 3.3. Summary of Policy Measures 3.4. Sample of Systemically Important Banks (as of 2012) 3.5. Benchmark Credit-Rating Estimation Results to Explain the Overall Ratings 3.6. Unit Rating Uplift: Robustness for Different Samples iv

International Monetary Fund | April 2014

4 4 13 20 20 25 25 37 46 54 55 56 56 57 64 70 71 77 79 88 91 94 95 96 118 121 122 127 130 130

CONTENTS

Figures 1.1. Global Financial Stability Map 2 1.2. Global Financial Stability Map: Assessment of Risks and Conditions 3 1.1.1. Trends in Indebtedness in Selected Advanced Economies since the Crisis 5 1.2.1. Japanese Financial System 7 1.3.1. Asset Class Performance 10 1.3. Federal Reserve Lending Survey and Institute for Supply Management New Orders: Green Shoots? 12 1.4. U.S. Nonfinancial Corporations: Credit Cycle Indicators 12 1.5. U.S. Nonfinancial Corporations: Key Financial Indicators 12 1.6. S&P 500: Price-to-Earnings Ratio 13 1.7. Decomposition of Equity Market Performance 13 1.8. U.S. High-Yield Bond and Leveraged Loan Issuance with Lower Standards 13 1.9. Leveraged Loans: Debt-to-EBITDA Ratio for Highly Leveraged Loans 13 1.10. U.S. Nonfinancial Corporations: Market-Based Financing 15 1.11. Federal Reserve Guidance Gaining Credibility? 16 1.12. Ten-Year U.S. Treasury Rate Projections Based on Exit Scenarios 17 1.13. Global Interest Rate Scenarios 19 1.14. Bond Flows to Emerging Market Economies and Domestic Credit in the Face of Tighter External Conditions 23 1.15. Private Sector Gross Debt and Credit in Selected Emerging Market Economies 26 1.16. Current Account Balance and Real Rates Now and Before the Financial Crisis 26 1.17. Policy Space 27 1.18. Ratio of International Reserves to 2014 External Financing Requirements 27 1.19. Coverage of Current Account by Foreign Direct Investment 28 1.20. Corporate Debt in Emerging Markets 29 1.21. Emerging Market Bank Resilience 31 1.22. China: Wealth Management Products and Trusts 33 1.23. China: Selected Financial Sector Developments 34 1.24. Total and Retail Portfolio Flows to Selected Emerging Market and Other Economies 36 1.25. Share of Nonresidential Holdings of Local Currency Government Debt and Market Liquidity 36 1.26. Summary of Selected Emerging Market Policy Actions since May 2013 38 1.27. Bank Credit and Market Indicators 40 1.28. Euro Area Bank Asset Quality 45 1.7.1. Change in Large European Union Bank Core Tier 1 Capital Ratios 47 1.7.2 Changes in European Union Bank Exposures, 2010:Q4–2013:Q2 47 1.29. Euro Area Bank Profitability, Buffers, and Interest Rates 48 1.30. Assets of Banks in the Euro Area 49 1.31. Simulated Cumulative Response of Bank Corporate Credit 49 1.32. Euro Area Write-Down Potential 50 1.33. Strength of Insolvency Procedures and Nonperforming Loans in Advanced Economies, 2013 50 1.34. Sources of Nonfinancial Corporate Credit, 2013:Q3 53 1.35. Term Premium Estimates under Alternative Affine Models 55 1.36. CEMBI Model Quarterly Spreads and Model Fits 60 1.37. Vector Autoregression Model Residuals 62 1.38. Comparing the Effects on Credit of One-Time Shocks: Cumulative Impulse Response Functions 63 2.1. Investor Base for Bonds in Emerging Markets 68 2.2 Trends in Capital Flows to Emerging Markets 72 2.3. Transformation of Investment Options in Emerging Markets 73 2.4. Emerging Markets: Shares in Economic Activities and Financial Markets 74 2.2.1. Financial Deepening in Emerging Markets 75 2.3.1. Investments of Institutional Investors in Emerging Markets 78 2.5. Allocation to Emerging Market Assets 80

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2.6. Integration of Emerging Market Assets into Global Markets 2.7. Herding among Equity and Bond Funds Investing in Emerging Markets 2.4.1 Role of Macroeconomic Fundamentals over Time 2.8. Mutual Fund and Institutional Investor Flows 2.9. Cumulative Monthly Portfolio Flows to Emerging Markets from Different Types of Investors during Distress Episodes 2.10. Flow Sensitivity to Global Financial Conditions by Fund Characteristics 2.11. Drivers of Global and Dedicated Funds’ Flows into Emerging Markets around the Global Financial Crisis 2.12. The Effects of Financial Deepening on the Sensitivities of Asset Returns to Global Risk Factor 2.13. Sensitivity of Local Yields to Portfolio Flows and Decline in Global Market Making 3.1. Effects of Too-Important-to-Fail Protection on a Simplified Bank Balance Sheet 3.2. Changes in the Number of Banks and the Size of the Banking Sector 3.3. Total Assets of Large Banks 3.4. Concentration in the Banking Sector 3.1.1. Cross-Border Banking Linkages 3.1.2. Global Banking Network: Core Countries 3.5. Bond Spread Differential between Systemically Important Banks and Other Banks 3.6. U.S. Banks’ Average Bond Duration 3.7. Bond Spread Differential for U.S. Banks with Similar Leverage 3.8. Mean Implicit Subsidy for Systemically Important Banks Estimated with the Contingent Claims Analysis Approach 3.9. Implicit Subsidy by Type of Bank in the United States 3.10. Average Subsidies Derived from Credit Ratings 3.11. Subsidies Derived from Credit Ratings for a Bank Just Below Investment Grade 3.12. Implicit Subsidy Values for Global Systemically Important Banks 3.13. Event Tree of Government Policies to Deal with Systemically Important Banks 3.6.1. Additional Tier 1 Capital Requirements for Systemic Banks

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81 81 82 84 85 86 87 89 90 103 105 106 106 107 107 109 111 111 112 113 115 116 119 122 126

CHAPTER

1

ASSUMPTIONS AND CONVENTIONS

The following conventions are used throughout the Global Financial Stability Report (GFSR): . . . to indicate that data are not available or not applicable; –

between years or months (for example, 2013–14 or January–June) to indicate the years or months covered, including the beginning and ending years or months;

/

between years or months (for example, 2013/14) to indicate a fiscal or financial year.

“Billion” means a thousand million. “Trillion” means a thousand billion. “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to ¼ of 1 percentage point). If no source is listed on tables and figures, data are based on IMF staff estimates or calculations. Minor discrepancies between sums of constituent figures and totals shown reflect rounding. As used in this report, the terms “country” and “economy” do not in all cases refer to a territorial entity that is a state as understood by international law and practice. As used here, the term also covers some territorial entities that are not states but for which statistical data are maintained on a separate and independent basis.

Further Information and Data This version of the GFSR is available in full through the IMF eLibrary (www.elibrary.imf. org) and the IMF website (www.imf.org). The data and analysis appearing in the GFSR are compiled by the IMF staff at the time of publication. Every effort is made to ensure, but not guarantee, their timeliness, accuracy, and completeness. When errors are discovered, there is a concerted effort to correct them as appropriate and feasible. Corrections and revisions made after publication are incorporated into the electronic editions available from the IMF eLibrary (www.elibrary.imf.org) and on the IMF website (www.imf.org). All substantive changes are listed in detail in the online tables of contents. For details on the terms and conditions for usage of the contents of this publication, please refer to the IMF Copyright and Usage website, www.imf.org/external/terms.htm.

International Monetary Fund | April 2014 vii

PREFACE

The Global Financial Stability Report (GFSR) assesses key risks facing the global financial system. In normal times, the report seeks to play a role in preventing crises by highlighting policies that may mitigate systemic risks, thereby contributing to global financial stability and the sustained economic growth of the IMF’s member countries. The global financial system is currently undergoing a number of challenging transitions on the path to greater stability. These transitions are far from complete, and stability conditions are far from normal. For advanced and emerging market economies alike, a successful shift from liquidity-driven to growth-driven markets requires a number of elements. The current report discusses these elements, including a normalization of U.S. monetary policy that avoids financial stability risks; financial rebalancing in emerging market economies amid tighter external financial conditions; further progress in the euro area’s transition from fragmentation to robust integration; and the successful implementation of Abenomics in Japan to deliver sustained growth and stable inflation. The report also examines how changes in the investor base and financial deepening affect the stability of portfolio flows and asset prices in emerging market economies. The findings suggest that changes in the composition of investors are likely to make portfolio flows to emerging market economies more sensitive to global financial conditions; however, strengthening local financial systems reduces the sensitivity of domestic financial asset prices to global financial shocks. Last, the report looks at the issue of institutions deemed too important to fail and provides new estimates of the implicit funding subsidy received by systemically important banks. The report finds that this subsidy is still sizable and calls for a strengthening of financial reforms. The analysis in this report has been coordinated by the Monetary and Capital Markets (MCM) Department under the general direction of José Viñals, Financial Counsellor and Director. The project has been directed by Jan Brockmeijer and Peter Dattels, both Deputy Directors, as well as by Gaston Gelos and Matthew Jones, both Division Chiefs. It has benefited from comments and suggestions from the senior staff in the MCM Department. Individual contributors to the report are Isabella Araujo Ribeiro, Nicolás Arregui, Serkan Arslanalp, Sofiya Avramova, Luis Brandao-Marques, Eugenio Cerutti, Yingyuan Chen, Julian Chow, Fabio Cortes, Pragyan Deb, Reinout De Bock, Marc Dobler, Martin Edmonds, Johannes Ehrentraud, Jennifer Elliott, Michaela Erbenova, Luc Everaert, Xiangming Fang, Florian Gimbel, Brenda González-Hermosillo, Dale Gray, Pierpaolo Grippa, Sanjay Hazarika, Geoffrey Heenan, Hibiki Ichiue, Bradley Jones, David Jones, William Kerry, Oksana Khadarina, Yoon Sook Kim, Koralai Kirabaeva, Frederic Lambert, Paul Mills, Camelia Minoiu, Prachi Mishra, Kenji Moriyama, Papa N’Diaye, Oana Nedelescu, Lam Nguyen, Erlend Nier, S. Erik Oppers, Hiroko Oura, Evan Papageorgiou, Vladimir Pillonca, Jean Portier, Shaun Roache, Luigi Ruggerone, Narayan Suryakumar, Shamir Tanna, Kenichi Ueda, Constant Verkoren, Chris Walker, Christopher Wilson, Tao Wu, and Xiaoyong Wu. Magally Bernal, Carol Franco, Juan Rigat, and Adriana Rota were responsible for wordprocessing. Joe Procopio and Linda Griffin Kean from the Communications Department edited the manuscript and managed production of the publication with assistance from Lucy Scott Morales and Linda Long. This particular edition of the GFSR draws in part on a series of discussions with banks, securities firms, asset management companies, hedge funds, standards setters, financial consultants, pension funds, central banks, national treasuries, and academic researchers. This GFSR reflects information available as of March 24, 2014. The report benefited from comments and suggestions from staff in other IMF departments, as well as from Executive Directors following their discussion of the Global Financial Stability Report on March 21, 2014. However, the analysis and policy considerations are those of the contributing staff and should not be attributed to the IMF, its Executive Directors, or their national authorities.

viii


EXECUTIVE SUMMARY

T

he global financial system is undergoing a number of challenging transitions on the path to greater stability. As the economic recovery in the United States gains footing, U.S. monetary policy has begun to normalize. Emerging market economies are transitioning to more sustainable growth in the financial sector, while addressing macroeconomic vulnerabilities amid a less favorable external financial environment. The euro area is strengthening bank capital positions as it moves from fragmentation to a more robust framework for integration. These transitions are far from complete, and stability conditions are far from normal. Since October, bouts of financial turbulence have highlighted the substantial adjustment that lies ahead. In advanced economies, financial markets continue to be supported by extraordinary monetary accommodation and easy liquidity conditions. They will need to transition away from these supports if they are to create an environment of self-sustaining growth, marked by increased corporate investment and growing employment. For advanced and emerging market economies alike, a successful shift from “liquidity-driven” to “growthdriven” markets requires a number of elements, including a normalization of U.S. monetary policy that avoids financial stability risks; financial rebalancing in emerging market economies amid tighter external

Transition from Liquidity- to Growth-Driven Markets United States

Normalizing monetary policy: a “Goldilocks” exit?

Emerging markets

As the tide of liquidity ebbs: more financial balancing needed

Euro area

From fragmentation to robust integration: progress, but picture still mixed

Japan

From deflation to reflation: so far so good, but much work lies ahead

financial conditions; further progress in the euro area’s transition from fragmentation to robust integration; and the successful implementation of “Abenomics” to deliver sustained growth and stable inflation in Japan. The gradual shift to self-sustaining growth is most advanced in the United States, where green shoots are evident from the economic recovery under way, as noted in the April 2014 World Economic Outlook. The U.S. transition presents several challenges to financial stability. The “search for yield” is becoming increasingly extended, with rising leverage in the corporate sector and weakening underwriting standards in some pockets of U.S. credit markets. Weaker market liquidity and the rapid growth of investment vehicles that are vulnerable to redemption risk could amplify financial or economic shocks. In this transitional period, the reduction in U.S. monetary accommodation could have important spillovers to advanced and emerging market economies alike as portfolios adjust and risks are repriced. Amid this shifting global environment, emerging market economies face their own transition challenges, but with substantial differences across economies. Private and public balance sheets have become more leveraged since the beginning of the crisis and thus are more sensitive to changes in domestic and external conditions. Macroeconomic imbalances have increased in a number of economies in the past few years, while the increased participation of foreign investors in domestic bond markets exposes some economies to an additional source of market volatility and pressure on capital flows. These developments have created a “systemic liquidity mismatch,” that is, a disjunction between the potential scale of capital outflows and the capacity of local institutions and market makers (in particular, international banks) to intermediate them. This bottleneck could magnify the impact of any shocks emanating from other economies and broaden the impact on asset prices, particularly if asset managers seek to hedge exposures by taking positions in more liquid but unrelated markets. The mismatch could create circumstances where authorities may have to provide liquidity

International Monetary Fund | April 2014 ix


to particular distressed markets to keep local bond and money markets working and contain spillovers across economies. In the corporate sector of emerging market economies, this report suggests companies in many cases have sufficient buffers to withstand normal domestic or international shocks, although some vulnerabilities are evident. In a severe and adverse scenario where borrowing costs escalate and earnings deteriorate significantly, the debt at risk held by weaker, highly leveraged firms could increase by $740 billion, rising on average to 35 percent of total corporate debt in the sample of firms. In most emerging market economies, reported bank capital buffers and profitability generally remain high and should be sufficient to absorb moderate shocks to nonfinancial companies. Nonetheless, in several economies, weak provisioning and lower levels of bank capital could present difficulties in the event of further balance sheet deterioration in the corporate sector. In China, the challenge for policymakers is to manage an orderly transition toward more market discipline in the financial system, including the removal of implicit guarantees. In this process, investors and lenders will have to bear some costs of previous financial excesses, and market prices will need to adjust to more accurately reflect risks. Pace is important. If the adjustment is too fast, it risks creating turmoil; if too slow, it will allow vulnerabilities to continue building. Other keys to the success of an orderly transition include upgrading the central bank’s ability to address unpredictable shifts in liquidity demand, timely implementation of deposit insurance and interest rate liberalization, and strengthening the resolution framework for failed financial institutions. In the euro area, policies implemented at both the national and European levels are supporting the transition to a more robust framework for integration, but important challenges remain. The restructuring of the debt-burdened euro area corporate sector has been stalled by the unfinished repair of bank balance sheets. Moreover, credit conditions remain difficult in stressed euro area economies. Although market sentiment regarding stressed euro area banks and sovereigns has improved markedly, it may be running ahead of the necessary balance-sheet repair. Thus, European policymakers must push ahead with a rigorous and transparent assessment of the current health of the banking system, followed by a determined cleansing of balance sheets and the removal of banks that are no longer viable. Additional measures to improve nonbank credit x


and equity channels are also required. The resulting tangible strengthening of balance sheets will help reinforce the improved optimism in financial markets. In Japan, continued monetary accommodation is necessary but not sufficient for renewed economic dynamism to take root. The transition to higher sustained growth and lower debt-related risks requires the enactment of persuasive structural reforms. The first stages of Abenomics have been largely successful in altering deflationary expectations, but consolidating these gains in financial stability and expanding them will require continued efforts. More broadly, maintaining the momentum and impetus for reform and good policies may prove challenging, amid a crowded electoral calendar in many countries. Geopolitical risks related to Ukraine could also pose a more serious threat to financial stability if they were to escalate. Greater spillovers to activity beyond neighboring trading partners could emerge if further turmoil leads to a renewed bout of increased risk aversion in global financial markets, or from disruptions to trade and finance. Against this backdrop, there is a need for strengthened and cooperative policy actions to help reduce risks of renewed turmoil in the global economy, both by reducing external imbalances and their associated internal distortions and by improving market confidence. Furthermore, an enhanced dialog between supervisors in advanced and emerging market economies should help ensure that cross-border liquidity and credit are not disrupted. Chapter 2 discusses the evolving landscape of portfolio investment in emerging market economies over the past 15 years. Their financial markets have deepened and become more globalized. Greater direct participation by global investors has stimulated the development of new asset class segments, including local currency sovereign debt markets. The mix of global investors has also changed, and bond funds have become more prominent—especially local currency funds, open-end funds with easy redemption options, and funds investing only opportunistically in emerging market economies. Chapter 2 draws on a variety of methods and relatively unexploited data to examine the implications of these changes for the stability of portfolio flows and asset prices in emerging market economies. It finds that changes in the composition of global portfolio investors are likely to make overall portfolio flows more sensitive to global financial shocks. The share of more volatile bond flows has risen, and larger

EXECUTIVE SUMMARY

foreign participation in local markets can transmit new instability. The growing activity of institutional investors is potentially more stable, but when facing an extreme shock, they can pull back even more strongly and persistently than other asset managers. While domestic macroeconomic conditions matter, herd behavior among global funds continues, and there are few signs that differentiation along local macroeconomic fundamentals during crises has increased over the past 15 years. However, the progress made so far by emerging market economies in promoting a larger local investor base, deepening their banking sectors and capital markets, and improving their institutions has reduced their sensitivity to global financial shocks. A continuation of these efforts can help emerging market economies reap benefits from financial globalization while minimizing its potential costs. Chapter 3 looks at how implicit funding subsidies for banks considered too important to fail (TITF) have changed over the past few years. Government protection for TITF banks creates a variety of problems: an uneven playing field, excessive risk taking, and large costs for the public sector. Because creditors of TITF institutions do not bear the full cost of failure, they are willing to provide funding without paying much attention to the banks’ risk profiles, thereby encouraging leverage and risk taking. During the global financial crisis, governments intervened with large amounts of funds to support distressed banks and safeguard financial stability, leaving little uncertainty about their willingness to bail out failing

TITF institutions. These developments have further reinforced incentives for banks to become large, and indeed, the concentration of the banking sector in many economies has increased. In response, policymakers have undertaken ambitious financial reforms to make the financial system safer, including addressing the TITF problem. Chapter 3 assesses whether these policy efforts are sufficient to alleviate the TITF issue. In particular, it investigates the evolution of the funding cost advantages enjoyed by systemically important banks (SIBs). The expectation of government support in case of distress represents an implicit public subsidy to those banks. This subsidy rose in all economies during the crisis. Although it has declined in most economies since then, it remains elevated, especially in the euro area, likely reflecting different speeds of balance-sheet repair as well as differences in the policy response to the problems in the banking sector. Nonetheless, the expected probability that SIBs will be bailed out in case of distress has remained high in all regions. Although not all measures have been implemented yet, there is still scope for a further strengthening of reforms. These reforms include enhancing capital requirements for SIBs or imposing a financial stability contribution based on the size of the liabilities of banks. Progress is also needed in facilitating the supervision and resolution of cross-border financial institutions. In these areas, international coordination is critical to avoid new distortions and negative crosscountry spillovers, which may have become even more important because of country-specific policy reforms.

International Monetary Fund | April 2014 xi

CHAPTER

1

MAKING THE TRANSITION FROM LIQUIDITYTO GROWTH-DRIVEN MARKETS

Financial stability has broadly strengthened in advanced economies. However, as the U.S. transitions to a less accommodative monetary policy stance, global financial conditions are tightening, which poses new challenges and reveals vulnerabilities in some emerging market economies. Those potential spillovers could, in turn, wash back onto the shores of advanced economies. The key challenge in this environment is to make a successful transition from policy accommodation to selfsustaining, investment-driven growth while minimizing spillovers that threaten financial stability.

I

n the wake of the global financial crisis, policymakers in most countries established a supportive macroeconomic environment to facilitate the repair of over-leveraged balance sheets that were exposed by the crisis. Accommodative monetary and liquidity policies have been an essential element of this response, aimed at minimizing the economic damage wrought by impaired financial systems, weakened companies, and stressed sovereign balance sheets. But the scaling back of certain extraordinary policy supports has not been accompanied by adequate preparations for a new environment of normalized, self-sustaining growth. Many advanced economies have been unable to sufficiently reduce precrisis debt loads— indeed, in general they have increased public indebtedness (Box 1.1). In the United States, green shoots are evident from the economic recovery under way, holding out the promise of self-sustaining growth, but further medium-term fiscal consolidation is required, as noted in the April 2014 Fiscal Monitor. Japan needs to complement its central bank’s additional monetary stimulus by enacting structural reforms to

Prepared by Peter Dattels and Matthew Jones (team leaders), Serkan Arslanalp, Yingyuan Chen, Julian Chow, Fabio Cortes, Reinout De Bock, Marc Dobler, Martin Edmonds, Jennifer Elliott, Michaela Erbenova, Xiangming Fang, Sanjay Hazarika, Geoffrey Heenan, Bradley Jones, David Jones, William Kerry, Koralai Kirabaeva, Paul Mills, Lam Nguyen, Erlend Nier, Evan Papageorgiou, Vladimir Pillonca, Jean Portier, Shaun Roache, Luigi Ruggerone, Narayan Suryakumar, Shamir Tanna, Constant Verkoren, Chris Walker, Christopher Wilson, and Tao Wu.

boost growth and reduce debt-related risks (Box 1.2). Emerging market economies face growing domestic vulnerabilities along with a heightened sensitivity to global conditions, and the euro area is confronted by the headwinds from the continued weakness of some corporate and bank balance sheets. After reviewing changes in overall global financial stability since the October 2013 Global Financial Stability Report (GFSR), this chapter examines the ongoing transition challenges confronting the global financial system. The next section considers stability risks in light of the gradual normalization of monetary policy in the United States and the possibility of international spillovers. The third section examines three key challenges faced by certain emerging market economies. First, after a prolonged period of inflows and rising credit, private and public balance sheets have become more debt-laden and thus more sensitive to changes in domestic and external conditions. Second, macroeconomic imbalances have increased in a number of economies, including China, where credit has risen sharply over the past five years. Increased foreign investor participation in domestic bond markets exposes some emerging market economies to an additional source of capital outflow pressures. Third, changes in underlying market structures have reduced market liquidity, which could act as a powerful amplifier of volatility in the event of renewed turbulence. The final section shows that, in the euro area, the incomplete repair of bank balance sheets and the corporate debt overhang in some economies are hampering both financial integration and the flow of credit to the real economy.

Financial Stability Overview Since the October 2013 GFSR, financial stability has improved in the advanced economies and deteriorated somewhat in emerging market economies. As described in the April 2014 World Economic Outlook, global activity strengthened in the second half of 2013 along the path broadly projected, primarily driven by recovery in the advanced economies. In the United States, improving domestic demand continues to strengthen


1


Figure 1.1. Global Financial Stability Map Risks Emerging market risks

Credit risks

Apr. 2014 GFSR Oct. 2013 GFSR

Market and liquidity risks

Macroeconomic risks

Away from center signifies higher risks, easier monetary and financial conditions, or higher risk appetite.

Monetary and financial

Conditions

Risk appetite

Source: IMF staff estimates.

the growth outlook. In the euro area, a pickup in growth has brightened prospects, although high debt, low inflation, and financial fragmentation still pre sent downside risks. However, the growth outlook for emerging market economies has been somewhat lowered by tightening external conditions coupled with some tightening of policy rates amid rising domestic vulnerabilities. Together, these developments leave macroeconomic risks unchanged (Figures 1.1 and 1.2). The firming up of the recovery in the United States has allowed the Federal Reserve to begin scaling back monetary stimulus. As a result, overall monetary and financial conditions have tightened, especially in emerging market economies, as real interest rates have increased. Tighter external conditions and rising risk premiums now confront emerging market economies as a number of them address macroeconomic weaknesses and shift to a more balanced and sustainable framework for financial sector activity. Box 1.3 highlights the periods of turbulence experienced in emerging market economies since May 2013, which reflect a general repricing of external conditions and domestic vulnerabilities in the wake of changing expectations about U.S. monetary policy. Against this backdrop, emerging market risks have risen as external conditions have tightened and the tide of liquidity has turned. 2


Credit risks have declined as vulnerabilities in banking systems have been reduced. In the euro area, banks have strengthened their capital positions amid ongoing deleveraging, resulting in higher price-to-book ratios and tighter spreads on credit default swaps. Despite a moderate deterioration in overall corporate credit quality, corporate spreads have narrowed. Better central bank communication regarding the process of normalizing U.S. monetary policy has helped quell the associated market volatility. With improved access to market funding for banks and nonfinancial corporations, market and liquidity risks remain broadly unchanged. The appetite for credit instruments and other risk assets remains firm, but the decline of demand for emerging market assets leaves overall risk appetite unchanged.

Normalizing U.S. Monetary Policy—A “Goldilocks” Exit? The United States faces several challenges to financial stability. The Federal Reserve’s tapering of its bond buying is setting the stage for a transition from liquiditydriven to growth-driven markets, but the search for yield is increasing, with rising leverage in the corporate sector and weakening underwriting standards in some

CHAPTER 1 Making the Transition from Liquidit y- to Growth-Driven Markets

Figure 1.2. Global Financial Stability Map: Assessment of Risks and Conditions (Notch changes since the October 2013 GFSR)

Macroeconomic risks remain balanced as growth improves in advanced economies and weakens in emerging markets. 2

Emerging market risks have increased, reflecting tighter external conditions and market turbulence. 2.

1.

2

More risk

More risk

1

1

0

0

Unchanged

–1

–1 Less risk –2

Overall (9)

Sovereign credit (1)

Less risk Inflation variability (1)

Economic activity (7)

Corporate sector (2)

Liquidity (2)

External financing (2)

Risk appetite remains unchanged overall as flows rotate into advanced economy equities and away from emerging markets. 4.

Market and liquidity risks remain unchanged overall. 2

Overall Fundamentals Volatility (10) (1) (3)

3.

Higher risk appetite

More risk

1 0

Unchanged

Unchanged

–1

–1 Less risk –2

3 2

1 0

–2

Overall (6)

Liquidity and funding (1)

Volatility (2)

–2

Lower risk appetite Market positioning (2)

Equity valuations (1)

Monetary and financial conditions have tightened, as real rates have increased in response to the U.S. tapering. 5. 2

Overall (4)

Institutional allocations (1)

Investor surveys (1)

Relative asset Emerging markets (1) returns (1)

–3

Credit risks have declined, led by improvements in bank funding conditions. 6.

2

Easier

More risk

1

1

0

0 –1

–1 Less risk

Tighter –2

Overall (6)

Monetary policy conditions (3)

Financial conditions index (1)

Lending conditions (1)

QE and CB balance sheet expansion (1)

Overall (8)

Banking sector (3)

–2 Corporate sector (3)

Household sector (2)

Source: IMF staff estimates. Note: Changes in risks and conditions are based on a range of indicators, complemented with IMF staff judgment (see Annex 1.1. in the April 2010 GFSR and Dattels and others (2010) for a description of the methodology underlying the Global Financial Stability Map). Overall notch changes are the simple average of notch changes in individual indicators. The number next to each legend indicates the number of individual indicators within each subcategory of risks and conditions. For lending standards, positive values represent a slower pace of tightening or faster easing. CB = central bank; QE = quantitative easing.

International Monetary Fund | April 2014 3


Box 1.1. Deleveraging Trends in Selected Advanced Economies •• Financial institutions have generally been the most successful in reducing their debt ratios. Debt has declined most sharply in Greece, Ireland, the United Kingdom, and the United States. But debt levels continue to be at the upper end of the range for the sample in Ireland, Japan, and the United Kingdom. Bank capital positions have improved in stressed euro area economies, but credit conditions remain strained, in part due to the incomplete state of bank balance sheet repair. •• Households have sharply reduced their debt levels (as a share of GDP) since 2009, especially

Since the global financial crisis, advanced economies have made uneven progress in deleveraging private balance sheets while generally increasing their public indebtedness. Table 1.1.1 shows current debt levels; Table 1.1.2 shows the varying degrees of progress in reducing debt loads from their postcrisis peaks; and Figure 1.1.1 shows sectoral debt during the past 10 years relative to 2008. The broad results are as follows:

Prepared by Reinout De Bock and Xiangming Fang.

Table 1.1.1. Indebtedness and Leverage in Selected Advanced Economies (Percent of 2013 GDP, unless noted otherwise) Canada

Japan

United Kingdom

United States

Euro area

Belgium

France

Germany

Greece

Ireland

Italy

Portugal

Spain

89 39 –2.6

243 134 –7.6

90 83 –4.5

105 81 –4.1

95 72 –0.4

100 82 0.4

94 88 –2.2

78 56 1.7

174 168 1.5

123 100 –3.4

133 111 2.0

129 118 –0.7

94 60 –4.2

Household liabilities 94 Gross financial1 Net financial –155

73 –261

95 –195

81 –292

71 –137

58 –217

68 –140

58 –126

71 –74

109 –91

56 –181

98 –138

84 –90

Nonfinancial corporates2 Gross debt3 47

78

73

54

68

...

68

43

66

115

78

118

99

Debt to equity (%)

Government Gross debt Net debt Primary balance

54

69

50

48

47

...

31

55

130

...

87

67

64

Financial institutions Gross debt4 51

196

242

83

153

101

165

95

24

699

105

45

109

Bank capital to assets (%)5

5.0

5.5

5.0

12.0

...

6.2

5.2

5.2

7.3

7.3

5.5

6.9

5.7

External liabilities Gross6 146 4 Net6

88 –64

597 –6

158 25

208 13

439 –46

322 21

209 –46

240 117

2,060 108

157 29

294 117

233 98

Current account balance

0.7

–3.3

–2.3

2.3

–1.7

–1.6

7.5

0.7

6.6

0.8

0.5

0.7

–3.2

Sources: ECB; national statistics; IMF: International Financial Statistics database, Financial Soundness Indicators (FSIs), and World Economic Outlook database; and IMF staff estimates. Note: Table shows most recent data available. Color coding is based on cross-country sample since 2009. Cells shaded in red indicate a value in the top 25 percent of a pooled sample of all countries since 2009. Green shading indicates values in the bottom 50 percent, yellow in the 50th to 75th percentile. 1Household debt includes all liabilities and not just loans. 2Includes an adjustment for estimated intercompany loans, where necessary. 3Some large multinational enterprises have group treasury operations in financial centers (e.g., Ireland), increasing corporate debt. 4High gross debt in Ireland in part reflects its role as an international financial services center. 5Data from IMF Financial Soundness Indicators database. Treatment of derivatives varies across countries. 6Data from IMF International Financial Statistics database.

Table 1.1.2. Reduction in Gross Debt Levels in Selected Advanced Economies from the 2009–13 Peak (Percent of GDP)

Government Household Nonfinancial corporates Financial institutions External liabilities

Canada

Japan

United Kingdom

United States

Euro area

Belgium

France

Germany

Greece

Ireland

Italy

Portugal

Spain

0.0 0.0 2.9

0.0 6.3 4.7

0.0 12.3 9.8

0.0 16.3 0.0

0.0 1.8 5.6

0.0 0.0 ...

0.0 0.6 1.1

4.4 6.9 6.6

0.0 5.0 7.3

0.0 22.7 9.8

0.0 0.6 4.7

0.0 7.7 1.3

0.0 8.6 21.1

6.4

4.0

40.4

35.6

7.5

25.7

13.8

38.1

51.2

50.1

4.9

24.1

16.7

0.0

0.0

167.3

10.0

8.2

48.6

0.0

27.6

0.0

24.4

1.1

18.1

5.1

Sources: ECB; national statistics; IMF: International Financial Statistics database, Financial Soundness Indicators (FSIs) and World Economic Outlook database; and IMF staff estimates.

4



Box 1.1 (continued) Figure 1.1.1. Trends in Indebtedness in Selected Advanced Ecomomies since the Crisis (Index: 2008 = 100) Canada

Euro area

Japan

1. Gross Government Debt

United States

United Kingdom

2. Gross Household Debt

180

120

160

110

140

100

120 90

100

80

80 60

2003

05

07

09

11

13

3. Gross Nonfinancial Corporate Debt

2003

05

07

09

11

13

70

4. Gross Financial Institution Debt

120

120 110

110

100 90

100

80 70

90

60 80

2003

05

07

09

11

13

2003

05

07

09

11

13

50

Sources: National statistics; IMF, World Economic Outlook database; and IMF staff calculations.

in program countries as well as in Japan, the United Kingdom, and the United States. But gross household debt remains high in Ireland, Portugal, and the United Kingdom. Despite optimism in banks and sovereigns, the net asset position of households remains weak in Greece, Ireland, and Spain. •• Although leverage among nonfinancial firms has come down from its peak in many economies, the corporate sector in parts of the euro area is still highly leveraged because countries have been slow to address the corporate debt overhang. In the United States, while corporate leverage is relatively low, companies have increased their borrowing in recent years.

•• Current account deficits have reversed sharply in southern Europe amid rapid import compression and improving competitiveness, even with significant public borrowing needs. But net foreign liabilities remain high in Greece, Ireland, Portugal, and Spain. •• The substantial progress made in repairing private balance sheets has come at the cost of public indebtedness (Figure 1.1.1), which is now at peak levels for many major economies. With the exception of Germany, government debt levels trended higher in 2013 for most economies. Among the sample economies, it remained highest in Greece, Italy, Japan, and Portugal even as Greece and Italy posted primary surpluses.



Box 1.1 (continued) In sum, still-high debt leaves balance sheets in some cases weak and less resilient to the higher interest rates that will come with monetary normalization. The corporate debt overhang in parts of the euro area needs to be resolved to complete the transition from financial

pockets of credit markets. Weaker market liquidity and the rapid growth of investment vehicles that are more vulnerable to redemption risk could amplify financial or economic shocks. Policymakers must carefully manage these growing risks to ensure stability and help achieve a smooth exit from unconventional monetary policies. The eventual path of the exit could have important international spillovers. Emerging market economies are especially vulnerable if U.S. term premia or expected short rates rise faster than expected. Managing the transition from liquidity-driven to growth-driven markets To achieve a smooth exit from unconventional monetary policy, the extraordinary monetary accommodation and liquidity conditions supporting markets must give way to increased corporate investment, higher employment, and self-sustaining growth. So where is the United States along this path of recovery? As discussed in the April 2014 World Economic Outlook, green shoots are becoming apparent: credit conditions have eased as bank balance sheets have strengthened, corporate loan demand has increased, and corporate investment appears set to increase (Figure 1.3). However, the current credit cycle differs from previous cycles in important ways (Figure 1.4). Debt issuance is much higher because corporations are borrowing opportunistically to take advantage of low interest rates and lengthening their debt maturities and pushing out refinancing risk to take advantage of investor appetite for debt. Balance sheet leverage has also risen via debt-financed buybacks of equity to boost shareholder returns. Thus, increased borrowing has not yet translated into higher investment by nonfinancial corporations, whose depressed capital expenditures are taking up a smaller share of internal cash flows than in previous cycles. Corporate leverage (the ratio of net debt to 6


fragmentation to integration. Emerging market economies that releveraged in the wake of the global financial crisis may now find it difficult to bring their financial systems in balance as volatility rises, growth slows, and exchange rates come under pressure.

GDP) is higher at this point of the cycle than during previous episodes, yet corporate default rates remain low (Figure 1.5).1 These characteristics of corporate balance sheets are typically seen at a much later stage of the credit cycle, suggesting that firms are more vulnerable to downside risks to growth than in a normal credit cycle. How much are side effects from accommodative monetary policies growing? The prolonged period of accommodative policies and low rates has led to a search for yield, which boosts asset prices, tilts the market balance in favor of borrowers, and sends funds into the nonbank financial system (FSB, 2013). All of these developments are part of the intended effects of extraordinary monetary policies, designed to support corporate and household balance sheet repair and promote the recovery. But these developments also have the potential side effect of elevating credit and liquidity risks. How large have these side effects become? Robust risk appetite has pushed up U.S. and European equity prices. U.S. equity prices are in line with the long-term trend of the regular price/earnings (P/E) ratio, but they are becoming stretched as measured by the Shiller P/E ratio (Figure 1.6). The largest contribution to the strong U.S. equity returns in 2013 came from a decline in the equity risk premium (Figure 1.7). In contrast, equities in emerging market economies stagnated, and in Japan, yen depreciation boosted earnings and returns. Further liquidity-driven boosts in asset prices could force overvaluation and lead to the development of bubbles. Looking ahead, markets risk disappointment—especially in an environment of rising interest rates—unless equity valuations become

1Corporate leverage indicators based on other metrics show the same trend.


Box 1.2. Is the Japanese Financial System Rebalancing, and What Are the Financial Stability Implications? When the Bank of Japan initiated its program of quantitative and qualitative monetary easing (QQE) in April 2013, it expected the program to affect the financial system through three channels: a further decline in long-term interest rates (“interest rate channel”); a rise in expected inflation (“expectations channel”); and a shift in the portfolios of financial institutions from Japanese government bonds to other assets, such as loans, stocks, and foreign securities (“portfolio rebalPrepared by Serkan Arslanalp.

ancing channel”). This box assesses progress in these channels, especially the portfolio rebalancing channel. The QQE program has so far had more success in the interest rate and expectations channels than in the portfolio channel. Yields on Japanese government bonds (JGBs) have remained low despite the rise in bond yields in other advanced economies (Figure 1.2.1, panel 1). Near-term inflation expectations have risen over the last year, although long-term expecta-

Figure 1.2.1. Japanese Financial System JGB yields have remained low despite the rise in bond yields in other advanced economies. 1. 10-Year Government Bond Nominal Yields (percent) 3.5

Canada

3.0

United Kingdom

Germany

Near-term inflation expectations have risen, although long-term expectations are still below 2 percent. 2. Inflation Expectations (percent; at end-2013) 2.5

Japan United States

2

2.5 2.0

1.5

1.5

1

1.0

0.5

0.5 0.0 Jan. 2012 July 12 Jan. 13 July 13 Jan. 14 Apr. 12 Oct. 12 Apr. 13 Oct. 13 Source: Bloomberg L.P.

Japanese banks have become net sellers of JGBs, as Bank of Japan now purchases more than net issuance of JGBs....

60 50 40

3. Net Japanese Government Bond Purchases (trillions of yen) Bank of Japan Depository corporations Public pension funds Other domestic Net issuance Foreigners Insurance and private pension funds

2014–16

2016–18

0

2018–23

Sources: Bloomberg L.P.; and IMF staff estimates. Note: Estimated as difference between breakeven rates of 3-, 5- and 10-year inflation-indexed bonds.

… reducing bank holdings of government debt and weakening sovereign-bank linkages. 4. Japanese Bank Holdings of Government Debt (percent of bank assets) PostQQE

Major banks Regional banks

25 20

30 20

15

10 0

10

–10 –20 –30

FY2011

FY2012

Apr.–Dec. 2013

Sources: Bank of Japan, Flow of Funds; and IMF staff estimates. Note: Fiscal year ends at end-March of following year. JGB = Japanese government bond.

Jan. 2007

Jan. 2009

Jan. 2011

Jan. 2013

5

Sources: Bank of Japan; and IMF staff estimates. Note: Government debt includes Japanese government bonds and treasury discount bills. QQE = quantitative and qualitative monetary easing.



Box 1.2 (continued) Figure 1.2.1. Japanese Financial System (continued) Meanwhile, banks are accumulating significant excess reserves, while domestic lending is picking up.

External bank loans continue to rise in excess of external deposits, adding to foreign exchange funding risks.

5. Japanese Banks: Excess Reserves and Domestic Lending (excess reserves as a percent of bank assets; year-over-year percent changes in loans) Major banks; loan growth (left scale) Regional banks; loan growth (left scale)

8 6

Major banks; excess reserves (right scale) Regional banks; excess reserves (right scale)

4 2 0 –2 –4 –6 Jan. 2007

Jan. 09

Jan. 11

9 8 7 6 5 4 3 2 1 0

Jan. 13

600 PostQQE 500

External loans External deposits

400 300 200 100 2007

2008

2009

2010

2011

2012

0

2013

Sources: Bank of Japan; and IMF staff estimates. Note: Domestic loans indicate bank lending to resident nonfinancial corporations and households.

Sources: Bank of Japan; and IMF staff estimates. Note: QQE = quantitative and qualitative monetary easing.

Outward portfolio investments increased in the second half of 2013, driven by banks...

… as home bias remains broadly in place for insurance companies and private pension funds.

7. Cumulative Outward Portfolio Investment of Selected Investors (trillions of yen; since end-2012) Banks 4 2 0 –2 –4 –6 –8 –10 –12 –14

Pension funds (public and private)

8. Japanese Insurance and Pension Funds: Foreign Security Holdings (percent of total assets)

Insurance companies Investment trusts

Insurance companies Private pension funds Public pension funds

24 PostQQE 22 20 18 16 14 12

Jan. Feb. Mar. Apr. May Jun. July Aug. Sep. Oct. Nov. 2013

Sources: Bank of Japan; and IMF staff estimates. Note: Pension fund flows are estimated from cross-border transactions in trust accounts of banks.

tions are still below the central bank’s 2 percent target (Figure 1.2.1, panel 2). But progress on portfolio rebalancing remains incomplete. Although JGB purchases by the Bank of Japan (BoJ) have helped major domestic banks shift out of JGBs

8

6. Japanese Banks: External Loans and Deposits (billions of U.S. dollars)


Mar. 2007

Mar. 08

Mar. 09

Mar. 10

Mar. 11

Mar. 12

Mar. 13

10

Sources: Bank of Japan, Flow of Funds; and IMF staff estimates. Note: QQE = quantitative and qualitative monetary easing.

and have reduced interest rate risk, both major and regional banks have accumulated large excess reserves at the BoJ, which could undermine their profitability. Moreover, outward portfolio investments (that is, net purchases of foreign securities) have picked up since


Box 1.2 (continued) mid-2013, but so far the trend appears to be limited mainly to banks and public pension funds. Japanese insurance companies and private pension funds continue to maintain a strong home bias and appetite for JGBs.

Banks Under QQE, domestic banks have been the main sellers of JGBs to the central bank (Figure 1.2.1, panel 3). Japanese banks sold about 20 trillion yen of JGBs between March and December 2013, according to the latest Flow of Funds data. All of Japan’s top three banks reduced their JGB portfolios during this period, and more recent data suggest that the selling continued through January. The resulting decline in holdings of government debt by the major banks weakened bank-sovereign linkages, as envisaged in the October 2013 GFSR (Figure 1.2.1, panel 4). Regional banks’ government debt holdings have also begun to decline, although regional banks rely on the income from JGBs more than major banks, and as a result, their duration risk remains high. Domestic lending is picking up, having risen during 2013 by 2 percent for major banks and 3 percent for regional banks. As lending picks up further, this could partly pare banks’ excess reserves at the BoJ, which are accumulating especially quickly for the major banks at a near zero interest rate (Figure 1.2.1, panel 5). Japanese banks continue to expand their overseas loan portfolios (Figure 1.2.1, panel 6), which exceed $500 billion for the first time in 15 years. Most of the rise in overseas loans reflects expansion into Association of Southeast Asian Nations countries, including Indonesia and Thailand. About 60 percent of external loans are financed through external deposits; the rest are financed through foreign-currency-denominated bonds and short-term lending instruments, such as foreign exchange swaps, to hedge foreign exchange risk. Banks are increasing their outward portfolio investments after having repatriated foreign assets in the first half of 2013 (Figure 1.2.1, panel 7). A significant portion of their portfolios include U.S. Treasury securities, whose yields now significantly exceed those of JGBs; the trend toward foreign bonds could continue if such differentials remain high.

Pension and insurance funds Insurance and private pension funds maintain a strong home bias and an appetite for JGBs (Figure 1.2.1, panel 8). Outward portfolio investments by

insurance companies have not risen substantially since March 2013 (Figure 1.2.1, panel 7). But they have risen for public pension funds, spurred by the recent shift in the asset allocation targets of the largest pension fund—the Government Pension Investment Fund—from JGBs to foreign securities, which portends further such investments (Figure 1.2.1, panel 8).1

Financial stability implications Should they persist, these trends have three major implications for financial stability. First, the rapid growth of excess reserves could create a substantial drag on bank profitability. This risk is more prominent for major banks, which already have 8 percent of assets in excess reserves earning near-zero interest rates. But the risk also exists for regional banks, whose profitability was low to begin with. A further pickup in lending would partly offset this drag, but such a pickup depends on raising credit demand in the economy, including through structural reforms. Second, the increase in cross-border activity of Japanese banks is welcome but poses foreign exchange funding risks and cross-border supervisory challenges. Further progress in securing stable and long-term foreign exchange funding is needed for Japanese banks to reduce their reliance on foreign exchange hedges. Third, the recent outward orientation of the largest public pension fund is a positive step. But, at $2 trillion, assets in all public pension funds are only onethird the size of assets held by private pension funds and insurance companies. QQE could become much more effective if those private sector asset managers were also to reduce their home bias and contribute to an overall portfolio rebalancing. Moreover, such an expansion of rebalancing could significantly boost the capital inflows of the recipient countries, especially if it were directed to those with relatively small markets. For example, a 1 percentage point shift of allocations by Japanese private sector asset managers to emerging market economies could boost their capital inflows by $60 billion.

1In late 2013, the Government Pension Investment Fund (with more than $1 trillion in assets under management) changed the portfolio weight of foreign securities from 17 percent to 23 percent. Over time, this could lead to capital outflows of more than $60 billion.



Box 1.3. Recent Periods of Turbulence in Emerging Market Economies changes in term premiums and in expectations about the path and timing of adjustment in U.S. rates had a profound impact on global markets. Exchange rates depreciated and interest rates rose sharply. Credit default swap (CDS) spreads jumped broadly across emerging markets—no one was spared from the anticipation of exit from extraordinary monetary policies in the United States. Emerging market economies with macroeconomic imbalances under strain (Phase 2, July

Emerging market economies have suffered bouts of market turbulence since May 2013 (Figure 1.3.1). This turbulence reflects a general repricing of external conditions and domestic vulnerabilities, as well as the new uncertainties for growth. Impact of U.S. monetary policy (Phase 1, May 21 to end-June 2013). Last May, as the Federal Reserve signaled steps toward normalizing monetary policy, Prepared by Peter Dattels and Matthew Jones.

Figure 1.3.1. Asset Class Performance (Percent change)

Phase 3 (Jan. to Mar. 21, 2014) Entire period (May 21, 2013 to Mar. 21, 2014)

Phase 1 (May 21 to end-Jun. 2013) Phase 2 (Jul. to end-Dec. 2013) 1. Foreign Exchange Rates

2. Local Currency Rates (two-year swap; basis point change)

50 40 30 20 10 0

3. Sovereign Credit Default Swap Spreads (five-year tenor; basis point change)

Hungary Thailand Singapore Mexico Korea Malaysia Poland Philippines China India South Africa Indonesia Russia Brazil Turkey 4. Equity Markets (percent change)

80

800 600 400 200 0 –200 –400 –600 –800 –1,000 –1,200

200 150 100 50 0 –50 Hungary Poland Korea Mexico Peru Philippines China Malaysia South Africa Indonesia Brazil Thailand India Russia Turkey Ukraine Argentina

–100

Right scale

60 40 20 0 –20 –40 –60 Turkey Hungary Brazil Indonesia Thailand Russia Philippines Peru Singapore Ukraine China Malaysia Mexico India South Africa Korea Poland Argentina

–20

Poland Korea Singapore Hungary China Peru Mexico Thailand Malaysia Philippines India Brazil South Africa Russia Indonesia Turkey Ukraine Argentina

–10

Sources: Bloomberg L.P.; Morgan Stanley Capital International.

10


800 700 600 500 400 300 200 100 0 –100 –200


Box 1.3 (continued) to end-December 2013). This period gave way to greater differentiation among economies as investors narrowed their focus to those economies with large external financing needs and/or other macroeconomic imbalances. Much of the attention was on Brazil, India, Indonesia, South Africa, and Turkey. Sovereign CDS spreads generally reversed, partly as a result of improved communication by the Federal Reserve. Idiosyncratic risks (Phase 3, January to midMarch 2014). Mid-January 2014 saw an outbreak of additional turmoil, this time triggered by idiosyncratic factors and several country-specific vulnerabilities. For instance, there were no broad-based market moves that would suggest increased concerns because the Federal Reserve had started to taper its bond purchases, nor did CDS markets signal a new round of emerging market credit stress. What stands out are market concerns about credit risk, a repricing of political risks in Thailand, concerns about policy vulnerabilities in Argentina, political risks in Turkey, and further pressure on South African markets. Importantly, though, countries that had taken policy actions since May 2013 showed increased resilience, with little pressure on India and Indonesia, for example. Growth worries? Equity markets are signaling continuing concerns about growth prospects in emerging market economies. Initially, the downturn related to concerns about tighter external conditions, but in more recent periods the focus has shifted to greater uncertainty surrounding growth prospects, even as the U.S. economy recovers and U.S. equities are in positive territory.

better supported by rising earnings, capital investment, and aggregate demand. The search for yield has allowed U.S. companies, including those rated as speculative, to refinance and recapitalize at a rapid pace. High-yield issuance over the past three years is more than double the amount recorded in the three years before the last downturn. This trend is accelerating, with gross issuance of highyield corporate bonds reaching a record $378 billion in 2013. Similarly, $455 billion in institutional leveraged loans were issued in 2013, far exceeding the previous high of $389 billion in 2007 (Table 1.1). As a result, U.S. high-yield bonds and leveraged loans reached $1.8 trillion outstanding at end-2013. In the face of such strong demand and favorable pricing, issuers have more frequently been able to issue debt with less restrictive conditions and fewer protec-

Geopolitical risks in Russia and Ukraine have so far had limited spillovers to broader markets. The financial impact of these political tensions has largely been confined to local markets, triggering an increase in Russian and Ukrainian sovereign credit risk, a sharp depreciation of the ruble and the hryvnia, and a rise in local bond yields. As direct economic and financial linkages of most European countries with Russia and Ukraine are limited outside the energy sector, spillovers have been modest so far. However, CIS countries, and to a lesser extent the Baltics, have strong links through trade, remittances, FDI, and bank flows to Russia and are likely to see a more significant impact. Greater spillovers to activity beyond neighboring trading partners could emerge if further turmoil leads to a renewed bout of increased risk aversion in global financial markets, or from disruptions to trade and finance. Impact on advanced economy markets. The recent bouts of turmoil in emerging markets have reverberated in mature markets, through several channels. Outflows have supported some safe haven assets—such as U.S. Treasury securities and Japanese government bonds—while advanced economy equity markets and inflows to the euro area have appeared to respond to emerging market weakness (notably in May–June 2013 and January–February 2014). The strength of these responses suggests that policymakers in advanced economies will increasingly need to take into account the spillover of their policies to emerging markets and the potential impact of these spillovers on their own economies.

tions for lenders. The proportion of bonds with lower underwriting standards (such as covenant-lite and second-lien loans) is on the rise, as it was before the financial crisis (Figure 1.8), and this could contribute, as it did then, to higher default rates and lower recoveries as the credit cycle turns. The normal risk premium of 30–35 basis points for covenant-lite loans has dwindled; despite their lower historical recovery rates, they now trade on par with comparable loans with stronger protections (OFR, 2013). Debt in highly leveraged loans now amounts to almost seven times EBITDA (earnings before interest, taxes, depreciation, and amortization), close to levels last seen in the 2006–08 period (Figure 1.9). U.S. bank regulators have publicly expressed concern about the increased incidence of leveraged loans with weaker underwriting standards, and market participants report increased


gLoBaL FInanCIaL staBILIt y rePort: MovIng FroM LIquIdIt y- to growth-drIven Markets

Figure 1.3. Federal Reserve Lending Survey and Institute for Supply Management New Orders: Green Shoots?

Figure 1.4. U.S. Nonfinancial Corporations: Credit Cycle Indicators

Corporate lending standards are loosening… 1. Corporate Lending Standards (net percent of respondents reporting loosening standards; four-quarter moving average) Easier

40

Large and medium Small

20 0 –20 –40 –60

Tighter 2004

05

06

07

08

09

10

11

12

13

14

Capital 100 expenditure 90 80 70 60 50 40 30 20 10 0 Previous Current cycles cycle

2. Corporate Loan Demand (net percent of respondents reporting stronger demand; four-quarter moving average) 40

Equity buyback (net)

Previous Current cycles cycle

Previous Current cycles cycle

Percent of internal cash flows

–80

…while corporate loan demand is rising…

Debt issuance (net)

Net debt (right scale)

50 45 40 35 30 25 20 15 10 5 0 Previous Current cycles cycle

Percent of GDP

Sources: Bank of America Merrill Lynch; Federal Reserve; and IMF staff estimates. Note: Credit cycles are identified based on actual default rates. They start when the default rate on high-yield corporate bonds, tracked by Bank of America Merrill Lynch, peaked in June 1991, January 2002, and October 2009, and cover the four-year period afterward. All variables are measured against internal cash flows over the four-year period, except for net debt, which is measured against GDP at end of the period.

20 0 –20 –40

2004

Large and medium Small 05 06 07 08

–60 09

10

11

12

13

14

–80

Figure 1.5. U.S. Nonfinancial Corporations: Key Financial Indicators (Percent) 24

… and new orders are growing at a faster pace. 3. ISM New Orders Index (six-month moving average; >50 indicates expansion)

22 70 65 60

45 40 35 2004

05

06

07

08

09

10

11

12

13

Sources: Federal Reserve; Institute for Supply Management; and IMF staff estimates. Note: ISM = Institute for Supply Management.

12


14

30

25 20 15

20 10

55 50

Net debt to total assets (left scale) High-yield corporate bond spread (right scale) High-yield corporate default rate (right scale)

18

5

16 0 March Mar. 03 Mar. 05 Mar. 07 Mar. 09 Mar. 11 Mar. 13 2001 Sources: Bank of America Merrill Lynch; Federal Reserve; and IMF staff estimates.


Figure 1.6. S&P 500 Price-to-Earnings Ratio

Figure 1.7. Decomposition of Equity Market Performance (Percent contributions in 2013)

50 Shiller P/E

45

One-year trailing price-to-earnings

40

70 60 50 40 30 20 10 0 –10 –20 –30

Risk-free rate Earnings (current and projected) Equity risk premium Total return in 2013

35 30 25 20 15 10

Long-term averages 1993

96

99

5

2002

05

08

11

14

United States

Emerging Europe Japan markets Sources: Bloomberg L.P.; International Broker's Estimate System; and IMF staff estimates. Note: Based on a three-stage dividend discount model.

0

Sources: Haver Analytics; and IMF staff estimates.

Table 1.1. Issuance Trends for U.S. High-Yield Bonds and Loans (Billions of U.S. dollars)

Weaker Underwriting of High-Yield Bonds

High-Yield Bond Ratings

2007 2008 2009 2010 2011 2012 2013

BB

B

CCC

NR

Total

Zero Coupon

31.8 14.1 58.9 80.1 80.4 103.6 128.8

67.0 25.7 103.5 177.7 131.9 195.5 172.4

50.6 12.9 14.9 39.3 39.8 57.3 72.9

4.4 2.5 2.2 6.6 5.3 9.3 4.2

153.9 55.2 179.5 303.7 257.4 365.7 378.3

0.5 0.5 0.0 0.3 1.0 0.0 0.0

Leveraged Loans

PIK Toggle

Total

17.5 6.6 1.9 0.9 3.7 7.0 15.2

18.0 7.1 1.9 1.2 4.6 7.0 15.2

Weaker Underwriting of Leveraged Loans

CLOs

Total

Secondlien

Covenantlite

Total

Total

388.8 72.4 38.3 158.0 231.8 295.3 454.9

30.2 3.0 1.5 4.9 7.0 17.2 28.9

115.2 2.5 2.7 8.0 59.1 97.5 279.1

145.3 5.5 4.3 12.9 66.1 114.7 308.0

93.1 18.0 0.6 4.2 13.2 55.5 82.2

Sources: Bank of America Merrill Lynch; and IMF staff estimates Note: CLOs = collateralized loan obligations; NR = not rated; PIK = payment-in-kind.

Figure 1.8. U.S. High-Yield Bond and Leveraged Loan Issuance with Lower Standards

Figure 1.9. Leveraged Loans: Debt-to-EBITDA Ratio for Highly Leveraged Loans

(12-month issuance as a percent of market size) 16 14 12

9

Zero coupon/PIK/toggle bonds (left scale)

60 8

Second-lien loans (left scale)

50

Covenant-lite loans (right scale)

7

40

10 8 6

30

6

20

5

4 10

2 0 Jan. 2001 Jan. 03

Jan. 05

Jan. 07

Jan. 09

Jan. 11

Sources: Bank of America Merrill Lynch; and IMF staff estimates. Note: PIK = payment-in-kind.

Jan. 13

0

2003

04

05

06

07

08

09

10

11

12

13

4

Sources: S&P Capital IQ. Note: Highly leveraged loans are defined as the top fifth of leveraged loans by initial Debt/EBITDA, with EBITDA over $50 million. EBITDA = earnings before interest, taxes, depreciation, and amortization.



regulatory scrutiny of loans to borrowers with debt in excess of six times EBITDA.2 Rising liquidity risks could amplify shocks and complicate the exit from extraordinary monetary policies Two liquidity-related trends could also pose stability risks: weaker market liquidity caused by reduced dealer inventories; and a significant shift in credit markets toward the involvement of investment vehicles that are more vulnerable to redemption risk. The confluence of these forces, combined with the increased prominence of the nonbank financial sector in credit provision, could complicate the Federal Reserve’s goal of achieving a smooth exit (Figure 1.10, panel 1). As described in previous editions of the GFSR, market making at banks has shrunk as they have become less willing to commit balance sheet resources to trading activity. Liquidity in the corporate bond market has thus declined, and investors find it increasingly difficult to execute large trades. Of more structural significance is the related increase in credit market investments via mutual funds and exchange-traded funds (ETFs). In their search for yield, investors have increased their demand for corporate credit exposure. Given the reduced inventory at banks, the share of corporate bonds and syndicated loans held by households, mutual funds, and ETFs now exceeds the share that traditional institutional investors such as insurance companies and pension funds hold directly or hold indirectly through collateralized loan obligations (CLOs) (Figure 1.10, panels 2 and 3). The concern is that if investors seek to withdraw massively from mutual funds and ETFs focused on relatively illiquid high-yield bonds or leveraged loans, the pressure could lead to fire sales in credit markets (Stein, 2013). Indeed, heavy outflows from corporate bond mutual funds and ETFs in May–June 2013 was accompanied by a rise in high-yield corporate bond spreads, in contrast with previous episodes when rising Treasury yields were accompanied by lower credit spreads (Figure 1.10, panels 4 and 6). Further liquidity risks could arise because leveraged loan mutual funds rely on bank lines of credit (LOCs) to meet redemptions, as loan sales typically take 20–25 days to settle. Banks that extend these lines to loan funds may also 2According to the Federal Reserve’s January Senior Loan Officer Opinion Survey, banks are reporting tighter debt-to-EBITDA restrictions on leveraged loans in response to the supervisory guidance issued in March 2013 (www.federalreserve.gov/boarddocs/snloansurvey).

14


have their own exposure to leveraged loans via balance sheet holdings, CLO warehouses, or total return swaps. In case of a disruption to the leveraged loan market, banks could be more likely to reduce LOCs, generating an adverse feedback loop. Mutual funds and fixed-income ETFs also have a liquidity mismatch with the over-the-counter assets they reference (Figure 1.10, panel 5). Occasionally, this liquidity mismatch creates a feedback loop between the funds and the underlying assets that can exacerbate selloffs, particularly when dealer inventories are too lean to act as a buffer.3 This feedback was seen in high-yield bonds in 2008. There is a risk that fire sales in illiquid markets could spill over to other sectors of the bond market and to a broader range of investors, particularly if it affects highly leveraged investors (such as mortgage real estate investment trusts and hedge funds), which rely on short-term funding. Managing a smooth exit from extraordinary monetary policies The previous discussion examined some of the pitfalls of current extraordinary monetary policies. Those aside, what are the inherent challenges of exiting from such policies? In May 2013, global markets were plunged into turmoil by the Federal Reserve’s announcement of its plans to taper the bond purchases that constituted one element of its extraordinary policies—quantitative easing. U.S. Treasury yields surged, and expectations for the eventual liftoff of the target policy rate were foreshortened. Global rates and volatility spiked, and emerging market economies came under substantial pressure. Since then, the Federal Reserve has persuaded markets that its decisions to reduce quantitative easing are independent of any decisions to hike policy rates. The improved communication reduced market volatility in the United States even as Treasury yields rose, and short-term rates somewhat decoupled from long rates (Figure 1.11, panel 1). Indeed, during the 3Flight-prone investors can reduce their exposures to exchangetraded products by selling ETFs and mutual funds. However, with market participants unable to trade large blocks of high-yield bonds, and dealers unwilling or unable to use their balance sheets to make markets, high-yield bond investors may find their portfolios depreciating rapidly with no way to meaningfully reduce their holdings. Under these circumstances, some investors may choose to hedge their high-yield bond portfolios by shorting the corporate bond ETF; that exacerbates selling pressure, which, in turn, necessitates additional ETF shorting to stay hedged.

CHAPTER 1

MakIng the transItIon FroM LIquIdIt y- to growth-drIven Markets

Figure 1.10. U.S Nonfinancial Corporations: Market-Based Financing Underwriting standards are weakening for syndicated loans to U.S. corporations... 1. Loans to U.S. Nonfinancial Corporations (billions of U.S. dollars) Bank loans Nonbank loans 1,400 (syndicated and finance company loans) 1,200 Syndicated loan transactions with weak underwriting standards 1,000 (percent; right scale) 800

… that are increasingly distributed through mutual and exchangetraded funds, rather than collateralized loan obligations.

30

2. Holders of Syndicated Loans to U.S. Nonfinancial Corporations (percent of total outstanding) Mutual funds, ETFs, and households ABS issuers (CLOs)

60

25

50

20

40

15

600

30

10

400

20

5

200 0 Dec. 2000 Dec. 02

Dec. 04

Dec. 06

Dec. 08

0 Dec. 12 Mar. 2000 Mar. 02

Dec. 10

10 Mar. 04

Mar. 06

Mar. 08

Mar. 10

Mar. 12

Sources: Federal Reserve; Shared National Credit Program; and IMF staff estimates.

Sources: Federal Reserve; and IMF staff estimates. Note: ABS = asset-backed security; CLO = collateralized loan obligation; ETF = exchange-traded fund.

Similarly, corporate bonds are increasingly held through mutual funds and ETFs.

These investment vehicles have more redemption risk, as suggested by the episode in May–June 2013.

3. Holders of U.S. Corporate Bonds (percent of total outstanding) Mutual funds, ETFs, and households Insurance and pension funds

45 40 35 30 25

20 March Mar. 02 Mar. 04 Mar. 06 Mar. 08 2000 Sources: Federal Reserve; and IMF staff estimates. Note: ETF = exchange-traded fund.

Mar. 10

Mar. 12

As dealers have reduced inventories, investment vehicles with redemption risk have grown… 5. U.S. Credit Mutual Fund Assets and Dealer Inventory (billions of U.S. dollars) Dealer inventory Mutual fund assets, including ETFs 2,500

4. Net Purchases of U.S. Corporate Bonds (billions of U.S. dollars) Mutual funds and ETFs (left scale) Insurance and pension funds (right scale) 120

50

100

40

80

30

60

20

40

10

20

0

0

2012:Q3

12:Q4

13:Q1

13:Q2

Sources: Federal Reserve; and IMF staff estimates. Note: ETF = exchange-traded fund.

… pushing up liquidity risk and leading to distortions in stress situations. 6. U.S. Treasury Sell-off Episodes (change in basis points) 10-year U.S. treasury rate

High-yield corporate bond spread

2,000 1,500 1,000 500

Q3 04 :Q 3 05 :Q 3 06 :Q 3 07 :Q 3 08 :Q 3 09 :Q 3 10 :Q 3 11 :Q 3 12 :Q 3 13 :Q 3

Q3

03 :

02 :

20

01 :

Q3

0

Sources: Federal Reserve; and IMF staff estimates. Note: ETF = exchange-traded fund.

–10

13:Q3

Oct. 1993– Nov. 94

Jan. 96– Jun. 96

Oct. 98– Jan. 2000

Jun. 03– Sep. 03

May. 13– Sep. 13

300 250 200 150 100 50 0 –50 –100 –150 –200

Sources: Bloomberg L.P.; Bank of America Merrill Lynch; and IMF staff estimates. Note: Episodes when 10-year U.S. Treasury rate rose by more than 100 bps within a year.


15


Figure 1.11. Federal Reserve Guidance Gaining Credibility? Short-term rates decouple from long-term rates... 1. Rates (percent) 3.5

1.4

3.0

1.2

2.5

1.0

2.0

0.8

1.5

0.6

1.0 0.5 0.0 Jan. 2013

0.4 10-year treasury (left scale) 3-month eurodollar futures, June 2015 (right scale) Apr. 13

July 13

Oct. 13

Jan. 14

0.2 0.0

...while volatility subsides. 2. 30-day moving average (index: Jan. 2013 = 100) 800 700

10-year treasury 10-year bund Emerging market currency Emerging market bond

600 500 400 300 200 100

Jan. 2013

Apr. 13

July 13

Oct. 13

Jan. 14

0

Sources: Bloomberg L.P.; JPMorgan Chase & Co.; and IMF staff estimates. Note: Emerging market economies are Brazil, China, India, Indonesia, Mexico, Russia, South Africa, and Turkey. Red shading is from May 22 to September 18; green shading is from September 19 to March 21.

first few months of 2014, volatility in emerging market economies was driven more by local conditions than by concerns about Federal Reserve tapering (Figure 1.11, panel 2). As the turbulence of last May demonstrated, the timing and management of exit is critical. Undue delay could lead to a further build-up of financial stability risks, and too rapid an exit could jeopardize the economic recovery and exacerbate still-elevated debt burdens in some segments of the economy. These trade-offs can be illustrated with three scenarios involving the pace and causes of exit. Scenario 1: Smooth Exit (falling stability risks). A sustained upturn in growth leads to a gradual normalization of monetary policy without undue financial stability risks or global spillovers. This is the baseline (most likely) scenario. 16


Scenario 2: Bumpy Exit (short-term stability risks). This adverse scenario, which is not the baseline, could be produced by higher-than-expected inflation, or growing concerns about financial stability risks. The result would likely be a faster rise in policy rates and term premia, widening credit spreads, and a rise in financial volatility that spills over to global markets, potentially exacerbated by a sudden shift in market perceptions of the Federal Reserve’s intended policy stance. Scenario 3: Delayed Exit (rising stability risks). This adverse scenario assumes that the Federal Reserve stops tapering its bond purchases after a few months because the real economy fails to gain traction; green shoots die, and markets become volatile while remaining trapped in a liquidity-driven mode. With the resulting extension of extraordinary monetary accommodation, potential financial stability risks build further. Under the smooth (baseline) exit scenario, the first hike in the target policy rate is assumed to take place in the second quarter of 2015, the timing of which is broadly in line with market expectations and the projections issued in conjunction with the March 2014 meeting of the Federal Reserve’s Federal Open Market Committee.4 The target policy rate is assumed to rise thereafter at a measured pace over 3½ years. However, unexpected developments may result in either the faster exit scenario (in which the liftoff in policy rates starts one quarter earlier than in the baseline) or the delayed exit scenario (in which liftoff starts a year later). Based on these assumptions, the expected shortterm rate (defined as the average target policy rate over the next 10 years) and the nominal constant maturity 10-year Treasury rate would evolve as in Figure 1.12. These expectations are highly sensitive to incoming data and changes in the perception of how the Federal Reserve may react to them.

4The projections are based on the median values in the summary of economic projections made by participants in advance of the March 2014 Federal Open Market Committee (FOMC) meeting; the participants’ projections are not voted on by the FOMC. The full summary of projections is appended to the meeting minutes (www. federalreserve.gov/monetarypolicy/files/fomcprojtab120140319. pdf ). FOMC voting members are a subset of FOMC participants. Participants are all seven members of the Federal Reserve Board (the Governors) and all 12 Federal Reserve Bank presidents; at a given FOMC meeting all Governors and five of the 12 presidents vote (one permanently and four on an annually rotating basis).


Figure 1.12. Ten-Year U.S. Treasury Rate Projections Based on Exit Scenarios Our assumed path for U.S. policy rates…

…determines the path of expected short rates…

1. U.S. Federal Reserve Polcy Rate (percent) 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Jan. 2013

2. Expected Short Rates (percent; average over next 10 years) 4.5 4.0 3.5 Smooth exit Bumpy exit Delayed exit

Jan. 15

Jan. 17

Jan. 19

Jan. 21

Jan. 23

Jan. 25

3. 10-Year U.S. Treasury Term Premium under Various Scenarios (percent) 1.4 1.2 1.0 0.8 0.6 Smooth exit Bumpy exit Delayed exit

0.2 0.0 –0.2

2014

15

16

17

18

Apr. 2014

Apr. 15

Apr. 16

Apr. 17

2.5 2.0 Apr. 18

… based on the Fed’s SOMA holdings…

…and an econometric model of the term premium…

0.4

3.0

Smooth exit Bumpy exit Delayed exit

19

20

4. U.S. Federal Reserve: System Open Marrket Account (SOMA) Holdings (trillions of U.S. dollars; January of each year) 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 Smooth exit Bumpy exit 1.0 Delayed exit 0.5 0.0 2008 09 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

… drives our projections for long-term U.S. Treasury rates. 5.5

5. U.S. 10-Year Treasury Rate (percent)

5.0 4.5 4.0 3.5

Smooth exit Bumpy exit Delayed exit Survey of Professional Forecasters (2014:Q1) Blue Chip Financial Forecasts (Feb. 2014)

3.0 2.5 2.0 1.5 Apr. 2014

Apr. 15

Apr. 16

Apr. 17

Apr. 18

Source: IMF staff projections. Note: Projections assume that the term premium component of the nominal 10-year constant maturity rate on Treasury securities reverts to its precrisis mean by 2020. Term premium projections are based on the size of the Federal Reserve’s balance sheet (its System Open Market Account holdings) and other macro-financial variables, as described in the October 2013 GFSR and in Wu (forthcoming). Projections of the target policy rate under the baseline scenario (smooth exit) assume that the Federal Open Market Committee (FOMC) initially increases the target rate by 25 basis points at a meeting in 2015:Q2 and follows up with equal increases at every second meeting until the rate reaches 4 percent. Under the bumpy (or delayed) exit scenario, the initial rise in the target policy rate starts one quarter earlier (or one year later). Moreover, under the bumpy exit scenario, the target rate rises by 25 basis points at every FOMC meeting rather than at every second meeting. The policy rate projections under the smooth exit scenario for end-2015 and end-2016 are broadly in line with the median values of the March 2014 economic projections of FOMC participants (appended to the minutes of the March 2014 FOMC meeting, www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20140319.pdf).



What are the implications of exit scenarios for longerterm interest rates? During May–December 2013, most of the rise in the nominal 10-year Treasury rate reflected an increase of 100 basis points in the term premium (Figure 1.13, panel 1).5 A return to historical norms for the premium could entail a further 100 basis point increase from its still depressed level of 10 basis points in February 2014.6 A model of the U.S. term premium and its impact on long-term rates indicates that, in each of the three exit scenarios, the premium rises to about 100 basis points but at a pace that differs across the scenarios (Figure 1.13, panel 2).7 The pace of U.S. monetary normalization is likely to significantly affect other economies Ten-year government bond yields tend to be highly correlated across major advanced economies, except for Japan (Figure 1.13, panel 3). The relationship is especially strong during periods of rapid increases in the U.S. rate (Table 1.2 and Figure 1.13, panel 4).8 A similar analysis for major emerging market economies shows a high degree of transmission from higher U.S. Treasury rates to local-currency bond yields, including during the selloff in 2013. Historical correlations and other statistical analysis for several advanced economies (Table 1.3 and Figure 1.13, panel 5) suggest that term premiums play a role in the transmission of interest rate shocks and that causation runs from the United States to the other economies. (See Annex 1.1 for details on the estimation of cross-country term premiums.) Hence, even if major central banks outside the United States can fully control expected short-term rates through 5Thus, the rise in the term premium accounted for two-thirds of the 150-basis-point increase in Treasury rates in 2013, according to an update of U.S. term premium estimates in Kim and Wright (2005). 6The 10-year U.S. Treasury term premium averaged about 130 basis points from 1990 to 2007 and 80 basis points from 2000 to 2007. 7The term premium model was also used in the October 2013 GFSR. The baseline scenario, which is broadly in line with the Federal Reserve’s current guidance on asset purchases, assumes that the central bank’s peak purchases of $85 billion per month in agency mortgage-backed securities and longer-term Treasuries will taper in $10 billion increments to zero, after which its holdings of those securities will roll off as they mature. 8Nonetheless, the impact varies by country and its degree of real and financial integration with the U.S. economy. Transmission has typically been highest for Canada, followed by the United Kingdom, Germany, and Japan.

18


forward guidance, these estimates suggest that normalization of the U.S. term premium could put upward pressure on long-term bond yields in other economies (Figure 1.13, panel 6, in which all changes in long-term bond yields come from changes in the term premium).9 Of course, an increase in both the term premium and expected shortterm rates would have an even larger impact. This changing external environment also has important implications for emerging market economies. A faster normalization of interest rates in advanced economies that is driven by faster growth could have positive spillovers, but very rapid normalization accompanied by a rise in volatility could be destabilizing. These issues are discussed in more detail in the next section, and the potential impact of various tapering scenarios on emerging market economies is discussed in Chapter 1 of the April 2014 World Economic Outlook. Navigating through the exit: key risks and policies The withdrawal of monetary accommodation by the Federal Reserve may be setting the stage for a smooth transition from liquidity-driven to growth-driven markets, but pockets of vulnerabilities may be emerging in credit markets. Potential shocks include a repricing of credit risks, a sudden increase in policy rate expectations, and a term premium shock. Potential amplifiers of these shocks could include weak market liquidity and redemption runs arising from an implicit mispricing of liquidity risks. These shocks are not independent; they could combine to produce an overshooting of rates and credit spreads and wider spillovers that would block a smooth transition. These risks argue for continued vigilance on the part of U.S. policymakers as they watch for possible deterioration on numerous fronts, including a weakening of underwriting standards in high-yield and leveraged loan markets, the increasing participation of investors with higher redemption risk in credit products, and a thinning of market liquidity buffers needed to absorb shocks in the event of a widespread market selloff.10 Macroprudential policies can help reduce excessive risk taking in the high9These scenarios are consistent with the analysis in Chapter 3 of the April 2014 World Economic Outlook, which shows that real interest rates are likely to rise moderately from their very low current levels. 10These and related issued have been discussed in a number of recent reports, including the 2013 annual report of the Financial Stability Oversight Council, the 2013 annual report of the Office of Financial Research, the latter’s 2013 report on asset management, and in speeches by some Federal Reserve Governors.

CHAPTER 1


Figure 1.13. Global Interest Rate Scenarios The rise in 10-year U.S. Treasury yields since May 2013 mainly reflects a rise in the term premium…

…which is still below historical norms and is expected to rise further as the Fed exits from asset purchases.

1. Decompositon of Changes in 10-Year Treasury Yield (basis point change since end-2012)

2. 10-Year U.S. Treasury Term Premium under Various Scenarios (percent) 1.4 Smooth exit

120 100 80

Expected short-term rates Term premium

May 22

Sept. 18

Bumpy exit Delayed exit

1.2 1.0 0.8

60

0.6

40

0.4

20

0.2

0

0.0

–20 Dec. 2012 Feb. 13

Apr. 13

Jun. 13

Aug. 13

Oct. 13

Dec. 13

2014

15

16

17

18

19

–0.2

20

Source: IMF staff estimates based on Kim and Wright (2005).

Source: IMF staff estimates based on Wu (forthcoming).

Long-term government bond yields are correlated across a number of major advanced economies despite differences in economic circumstances.

They tend to rise when U.S. Treasury rates rise, although the impact varies by economy.

3. 10-Year Government Bond Nominal Yields (percent)

4. 10-Year Government Bond Yield Changes During Rapid Rises in U.S. Treasury Yields (percent of the rise in U.S. treasury yield) 180 Range 160 Average change 140 120 100 99 88 86 80 73 66 60 57 60 40 36 20 0 Canada United Germany Japan South Mexico Poland Korea Africa Kingdom Sources: Bloomberg L.P.; and IMF staff estimates. Note: During these episodes 10-year U.S. Treasury rates rose by more than 100 basis points in less than a year (Oct. 93–Nov. 94; Jan. 96–Jun. 97; Oct. 98–Jan. 2000; Jun. 03–Sep. 03; and May 13–Sep. 13). For Korea, Mexico, Poland, and South Africa, only the last two episodes are considered for lack of comparable data.

8

Canada Germany Japan

7 6

United Kingdom United States

5 4 3 2 1 0 2000 01 02 03 04 05 06 07 08 09 10 11 12 13 Sources: National central banks; and Thomson Reuters.

Part of the transmission channel is through the term premia, suggesting monetary normalization in the United States could put…

… upward pressure on bond yields in other economies, even if their central banks can fully control expected short-rates.

5. Beta to U.S. Term Premium Shock (percent) 80

6. Potential Impact of a 100 Basis Point Rise in the U.S. Term Premium (percent) 3.5 3.5 United Kingdom Canada

60 40

62

2.5 1.5

56

Range Average beta coefficient

43

3.0 27

20 0

Japan United Germany Kingdom Source: IMF staff estimates. Note: Beta is the coefficient of the U.S. 10-year government bond term premium in the following regression: ΔTi,t = αi + ß × ΔTus,t + ∈i,t in which i = Canada, United Kingdom, Germany, and Japan. Range showing two standard deviations. Canada

2.0 1.0 Feb. 2013

Germany 35-55 bps Feb. 14

2.5

45-65 bps

50-70 bps

Feb. 15 Feb. 2013

Japan

1.5

15-35 bps

Feb. 14

2.0 1.0

0.0 Feb. 15

Source: IMF staff estimates. Note: bps = basis points. The projections are based on a one standard deviation range around the beta coefficient.


19


Table 1.2. Change in 10-Year Government Bond Yields (Percent of change in U.S. 10-year rate) Episode (start)

Episode (end)

Length (months)

Oct. 1993 Jan. 96 Oct. 98 Jun. 2003 May 13 Average

Nov. 1994 Jun. 96 Jan. 2000 Sep. 03 Sep. 13

13 5 15 3 4

Canada

Germany

Japan

Korea

Mexico

Poland

South Africa

United Kingdom

90 60 73 60 83 73

60 48 69 59 64 60

37 9 39 79 16 36

... ... ... 43 71 57

... ... ... 20 155 88

... ... ... 46 125 86

... ... ... 47 151 99

67 51 49 59 101 66

Sources: Bloomberg L.P.; and IMF staff estimates.

Table 1.3. Correlation and Beta between the Term Premium in the United States and Other Major Advanced Economies Correlation Beta Beta standard deviation

Canada

Germany

Japan

United Kingdom

0.89 0.62 0.04

0.71 0.43 0.06

0.50 0.27 0.07

0.80 0.56 0.06

Source: IMF staff estimates.

yield and leveraged loan markets and encourage more prudent underwriting of new credit products (Box 1.4), although regulators should be mindful of possible unintended consequences of financial regulatory reform, such as reduced liquidity in bond and repo markets. Through their Shared National Credits monitoring program, U.S. supervisors should continue to review the credit quality of large syndicated loans, including leveraged loans.11 Moreover, although the size of U.S. mortgage real estate investment trusts has modestly declined over the past year, authorities should continue their close oversight of them. As highlighted in the October 2013 GFSR, these leveraged vehicles could pose financial stability risks in an environment of sharply rising interest rates. Meanwhile, some of the new characteristics of the commercial real estate market, such as increased issuance of interest-only loans and subordinated debt, could pose risks if the housing recovery stalls. Supervisors should remain alert to any aggressive expansion of lending to riskier borrowers, particularly because such loans are often made with the intention of selling them. Financial sector turmoil can produce a rapid decline in risk appetite, as was the case in the global 11The updated supervisory guidance issued in March 2013 should help banks use more prudent underwriting standards when originating leveraged loans regardless of whether they intend to hold or distribute them. Indeed, the Federal Reserve’s January 2014 Senior Loan Officer Opinion Survey suggests that banks tightened lending standards in the leveraged loan market following the updated supervisory guidance.

20


financial crisis, leaving banks unable to sell their riskiest loans and unprepared to warehouse them for an extended period. Therefore, banks must limit the overall amount of high-risk loans in their syndication pipelines and ensure that their management information systems provide a continuous and accurate picture of their credit exposures. More broadly, U.S. supervisors should continue seeking a clearer view of bank-like activities in the more lightly regulated segments of the financial sector (shadow banking) that could pose a threat to the banking system. Entities such as business development companies and even hedge funds are increasingly providing credit to larger corporations but often lack access to official sources of liquidity. Existing supervisory frameworks may need updating to allow an expansion of efforts to identify and quantify such nonbank entities, some of which may grow sufficiently to warrant being designated as systemically important, and legal changes may be required to provide them with emergency liquidity. Regulators should also be prepared to identify financial products that may have become systemically important and to assess their stability implications.

Emerging Markets: External Risks and Transition Challenges Emerging market economies have benefited from favorable external financing conditions and strong credit growth, but these tailwinds have now reversed. Several emerging market economies facing market pressure took appropriate policy actions last year to facilitate macroeconomic rebalancing and preserve financial stability. The challenges facing many emerging market economies as they adjust to tighter external financing conditions and greater domestic vulnerabilities vary considerably from economy to economy but can be generally summarized as follows. First is the greater leverage on private and public balance sheets. Second is the increase in


Box 1.4. Macroprudential Policy in the United States The U.S. Federal Reserve has, since the global financial crisis, taken a range of policy actions to increase the resilience of the U.S. banking system. A key plank of this strategy is the Comprehensive Capital Analysis and Review program introduced in late 2010. This program builds on the Supervisory Capital Assessment Program initiated in the midst of the crisis. It subjects the largest banking groups to annual stress tests and holds these banks to capital requirements beyond the regulatory minimums. The Federal Reserve has also announced that large bank holding companies will need to have a leverage ratio above the Basel minimum and has established an Office of Financial Stability Policy and Research to strengthen its internal macroprudential analysis and policy development. At the onset of the global financial crisis, neither the Federal Reserve nor any other regulatory agency had a full overview or the tools to reach all aspects of the highly complex U.S. financial system. The principal legislative response was the establishment, through the 2010 Dodd-Frank Act, of the Financial Stability Oversight Council (FSOC), chaired by the Secretary of the Treasury. The FSOC brings together all federal financial regulators, including the Federal Reserve and the Securities and Exchange Commission, to collectively examine and mitigate financial stability threats. Its work is supported by an independent Office of Financial Research (OFR), which assesses and reports on threats to financial stability, as well as a subcommittee at the deputy level and several standing committees that bring together staff from the member agencies. The FSOC has strong powers to designate individual banks, nonbank institutions, and market infrastructures as systemically important.1 The designation subjects such entities to oversight by the Federal Reserve for adherence to heightened prudential standards. The FSOC also has the power to recommend that one or more regulatory agencies take action and can ask each recipient to “comply or explain”— that is, take the recommended action or explain why it will not do so. Although these arrangements were established fairly recently, some potential strengths and weaknesses can be discerned when compared with established IMF criteria (IMF 2013a and 2013b). This box was prepared by Erlend Nier. 1See Chapter 3 of the GFSR for more details on measures to address the too-important-to-fail issue.

A key strength of the Dodd-Frank framework is that it establishes the OFR as an agency mandated by statute to provide an independent assessment of financial stability risks. The OFR is also being given adequate resources (annual budget: $86 million) and has rapidly built up considerable expertise to fulfill its task. In line with recommendations by the Government Accountability Office (GAO, 2013), the OFR has developed a prototype Financial Stability Monitoring Framework, published in its 2013 annual report (OFR, 2013). The monitoring framework aims to identify key system vulnerabilities in a structured and comprehensive way and to assess how risk factors have evolved. A potential weakness of the arrangements is that the regulatory structure remains fragmented (IMF, 2010). Differences in those agencies’ perspectives can make it hard to reach agreement on key priorities and slow decision making. They can also impede implementation when agreement is reached, particularly if agreement was only by majority vote and not by consensus. Given that the ultimate power to take regulatory action rests with the agencies, FSOC recommendations may not develop traction in such cases, causing delay in implementation. An example of such tension is the protracted debate over reform of money market mutual funds. The relevant agencies followed the FSOC’s recommendations on the matter only partially and with considerable delay. These difficulties suggest that the process of issuing recommendations to member agencies could be too cumbersome if an important and time-sensitive systemic threat is identified (FSB, 2013). A way to partially overcome the structural implementation problems is for the FSOC to more extensively designate systemically important nonbank financial institutions, thereby moving primary supervisory oversight of them to the Federal Reserve. The FSOC used this power in 2013, when it designated three nonbank financial firms as systemically important. However, its designation power applies only to individual entities. Hence, it may not be the appropriate policy tool when systemic risk arises from products offered by a class of institutions, such as real estate investment trusts, or from the activities of a diverse range of nonbank institutions, such as the provision of leveraged loans. Few of the entities involved in such cases are likely to be individually systemically important; rather, it is their actions collectively that pose systemic risk.



Box 1.4 (continued) Overall, therefore, although the U.S. macroprudential policy framework has clear strengths, a number of issues merit consideration. For instance, as a means to further increase traction of FSOC recommendations, thought could be given to providing the FSOC with a “back-up” power to designate as sys-

macroeconomic imbalances for a number of economies, including in China’s nonbank financial sector, and the greater tendency of investors to differentiate between and reprice assets according to these imbalances. Third is the additional capital flow pressures from the increased presence of foreign portfolio investors together with changes in underlying market structures that have reduced market liquidity. Geopolitical risks related to Ukraine could also pose a more serious threat to financial stability if they were to escalate. Emerging market economies must rebalance as external conditions tighten Since 2009, the unconventional monetary policies and low interest rates in the advanced economies have accelerated the increase in global portfolio allocations to emerging market economies above its pre-2008 trend (Figure 1.14, panel 1). Through 2013, the stock of portfolio investment to emerging market fixedincome markets from advanced economies continued to increase, rising to an estimated $1.5 trillion ($1.7 trillion including valuation effects), or $480 billion above the extrapolated 2002–07 trend. The reach for yield by international investors has produced a steady decline in risk premiums and lowered the costs of financing in many emerging market economies. The rise in corporate debt issuance has been particularly striking. The global recovery from the financial crisis was supported by strong credit growth and public spending in emerging market economies, particularly in Asia, which helped strengthen private demand (Figure 1.14, panel 2). Credit growth has slowed since 2009 but still remains above GDP growth (Figure 1.14, panel 3). Nonetheless, as economic growth slows, the largest emerging market economies (Brazil, China, India, and Russia) have reached the late stage of the credit cycle, which is marked by deteriorating asset quality, increased leverage, and peaking asset prices (Figure 22


temically important well-defined classes of nonbank intermediaries that might collectively pose systemic risks. In addition, consideration could be given to strengthening constituent agencies’ existing powers to regulate products offered in wholesale and retail financial markets.

1.14, panel 4). In 2013, as asset returns adjusted to the prospect of slower growth and a less favorable external environment, the performance of fixed-income securities and equities in those four economies lagged that in the United States for the first time in 10 years. These changing circumstances pose a number of challenges for emerging market economies. First, the greater debt on private and public balance sheets makes them more sensitive to an increase in interest rates, a slowdown in earnings, and a depreciating currency. Second, macroeconomic imbalances, which have increased in a number of economies, in part because of previous accommodative policies, are now more difficult to finance because risk premiums have risen. In China, rapid growth of nonbank lending as part of the postcrisis credit stimulus now presents new challenges to stability and growth. Third, increased foreign investor participation exposes some economies to an additional source of capital outflow pressure. Reductions in liquidity from changes in underlying market structures could act as a powerful amplifier of volatility in the event of renewed bouts of market turbulence. The remainder of this section examines these challenges in detail and discusses the policies and adjustments that will help emerging market economies make the transition to more balanced financial sector growth. Many emerging market economies face larger debt stocks and higher leverage Since the global financial crisis, strong investor demand and the desire to support investment and growth have boosted private and public sector debt in many emerging market economies. As noted in the April 2014 Fiscal Monitor, average debt levels in emerging market economies are relatively low, but important pockets of vulnerability between economies


Figure 1.14. Bond Flows to Emerging Market Economies and Domestic Credit in the Face of Tighter External Conditions Inflows to emerging market bonds accelerated after 2009 and have increased to above-trend levels.

Rapid credit creation contributed to fast output growth over the last 12 years…

1. Bond Flows from Advanced to Emerging Market Economies (percent of advanced economies’ GDP)

2. Credit and GDP Growth Trends in Emerging Market Economies (percent)

6

$550 billion

Trend

5

Credit

GDP

Trend credit

25

Trend GDP

20

4

15

3

lative

Cumu

2

10

$480 billion

ws, tive flo Cumula tion effects a lu et of va

1 0

flows

5

n

2002 03

04

05

06

07

08

09

10

11

12

13 est.

2002 03

04

05

06

07

08

09

10

11

12

13

0

Sources: Haver Analytics; IMF, Electronic Data Sharing System; and IMF staff calculations. Note: Calculated for the following 21 economies: Brazil, Bulgaria, Chile, China, Colombia, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Turkey, and Ukraine.

…but credit and GDP growth have slowed sharply.

Asset performance in major emerging market economies has deteriorated against slower growth and higher leverage.

3. Real Credit and Real GDP Growth in Emerging Markets (percent)

4. Credit Cycle and Asset Performance in Brazil, China, India, Russia (percent)

20 2012:Q4 2009:Q2

18 16

12

2009:Q4

10

2013:Q1

2010:Q1

8 6

2012:Q2

2009:Q3

14

2013:Q2 0

2009:Q1

2012:Q3

2005

2007

2008:Q4

20 15 10

2010:Q4

5 2009

2010:Q3

2010:Q2 2013

2013:Q3

5 10 Real GDP growth (year over year)

Sources: Haver Analytics; IMF, Electronic Data Sharing System; and IMF staff calculations. Note: Calculated for the following 21 countries: Brazil, Bulgaria, Chile, China, Colombia, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Turkey, and Ukraine.

15

–10

2011

0 –5

Real credit growth relative to previous four-year average

Real credit growth (year over year)

Sources: IMF, Consolidated Portfolio Investment Survey; JPMorgan Chase & Co.; and IMF staff calculations. Note: The long-term trends were extrapolated from 2002–07. Flows for 2013 were calculated using the trend of 2009–12 and estimates on 2013 portfolio flows from balance of payments data. Valuation effects are removed by calibrating against returns in associated fixed income indices.

–10 –5 0 5 10 15 Asset performance in excess of U.S. Treasuries, S&P 500

Sources: Bloomberg L.P.; JPMorgan Chase & Co.; IMF, International Financial Statistics database; and IMF staff calculations. Note: Real credit growth is GDP weighted. Asset performance is asset class and country weighted in line with the MSCI EM and JPMorgan EMBI Global (diversified), CEMBI (diversified), and GBI-EM (broad diversified). CEMBI = Corporate Emerging Markets Bond Index; GBI-EM = Government Bond Index-Emerging Markets; MSCI EM = Morgan Stanley Capital International Emerging Markets Equity Index.



remain. In addition, public debt has risen in tandem with private sector indebtedness. Indeed, households in Asia and parts of Latin America increased their debt levels after 2008. Household debt in Brazil, China, Singapore, Thailand, and Turkey has increased more than 40 percent since 2008 (Figure 1.15, panel 1, and Tables 1.4 and 1.5), and in the second quarter of 2013 it accounted for more than 60 percent of GDP in Malaysia, Singapore, and Thailand. Countries in emerging Europe saw the fastest increase of household debt in the period leading up to the global financial crisis, and some are still dealing with the challenges of ongoing deleveraging. The nonfinancial corporate sector in several emerging market economies took advantage of the low rates and strong demand for their bonds since the crisis. As a result, median country-level balance sheet leverage for nonfinancial corporations has increased for some economies and has remained high in others. This sustained period of releveraging may have built up vulnerabilities that will be exposed by slower domestic growth and tighter financial conditions (Figure 1.15, panel 2). Macroeconomic adjustment and rising risk premiums Emerging market economies have begun adjusting to a gradual normalization of monetary conditions in advanced economies and the maturing of their own credit cycles. The adjustment is likely to last several years and may be punctuated by bouts of volatility. Macroeconomic and financial vulnerabilities are generally country specific, and the risk of a bumpy adjustment is higher where rebalancing and policy adjustment is judged by markets to be insufficient. Some emerging market economies still have large external current account imbalances and real interest rates that are still below precrisis levels (Figure 1.16). The less benign external environment will tend to make it more difficult to finance these imbalances, suggesting that further adjustments to the real rate and the macroeconomy may be required in these cases. Markets are also pricing in policy rate increases in economies where inflation rates are expected to remain above target levels (Figure 1.17). Turkey stands out because the market does not expect significantly more monetary policy tightening over the next 12 months, having frontloaded its monetary policy adjustment in January. In addition, Turkey’s external financing position for 2014 has increased meaningfully in relation to 24


its international reserves (Figure 1.18), and its reliance on portfolio flows to finance the current account in the absence of foreign direct investment presents adjustment challenges (Figure 1.19). Could external and macroeconomic adjustments crystallize vulnerabilities in the corporate sector? Against the backdrop of low global interest rates and ample liquidity, net issuance of emerging market corporate debt tripled from 2009 to 2013 (Figure 1.20, panel 1). Although strong economic growth prevented aggregate leverage ratios from growing excessively in most economies, the ratios of corporate debt to GDP appear high in Bulgaria, China, Hungary, and Malaysia, at 100 percent of GDP or more (Figure 1.20, panel 2). In China and Malaysia, corporate leverage is mostly funded from domestic banking and capital markets, thus rendering firms there more sensitive to domestic factors. In contrast, firms in Bulgaria and Hungary are more dependent on external financing, mostly from foreign direct investment. Slowing growth prospects are beginning to pressure corporations’ profitability and their capacity to service debt. Debt has grown faster than earnings in several economies, as shown by the increase in the ratio of net debt to EBITDA (Figure 1.20, panel 3).12 Even as low interest rates have enabled firms to reduce overall borrowing costs, higher debt loads have led to growing interest expense. In 2012, the annual growth rate of interest expense surpassed the five-year average in many economies (Figure 1.20, panel 4). As a result, debt servicing capacity has deteriorated, and the share of total corporate debt held by weak firms has risen since 2010 (Figure 1.20, panel 5).13 Debt at risk—the share of corporate debt held by weak firms—is even higher now than in the period following the September 2008 collapse of Lehman Brothers, and it is well above precrisis levels in Asia and in emerging Europe, the Middle East, and Africa.

12Net debt is computed as total debt less cash and cash equivalents. EBITDA, which refers to earnings before interest, taxation, depreciation, and amortization, accounts for capital outlays, particularly by large firms. The ratio shows how many years it would take to repay current debt at the present level of EBITDA. As total debt is reported based on accounting records of on-balance-sheet borrowings and excludes financial guarantees and other contingent liabilities, leverage as a whole may be understated in some firms. 13Weak firms are those whose interest coverage ratios (EBITDA divided by interest expense) are less than two.


Table 1.4. Debt, Leverage, and Credit in Selected Emerging Market Economies (End-2013 or latest available; percent of GDP, unless otherwise noted) Brazil

China

India

Indonesia

Malaysia

Mexico

Poland

Russia

Singapore

South Africa

Thailand

Turkey

General Government Debt Gross Net

66 34

22 ...

67 ...

26 ...

58 ...

46 40

57 29

13 ...

104 ...

45 39

45 ...

36 27

Household Debt Gross Debt to Income (percent)

26 ...

32 71

8 12

17 29

81 ...

14 23

35 58

14 27

73 159

45 78

80 118

20 27

Nonfinancial Corporate Debt Bank Credit Debt to Equity (percent)

30 77

141 50

48 83

19 66

... 39

11 59

43 39

36 60

71 46

31 32

52 57

42 47

Banking Sector Credit to Nonfinancial Private Sector1 Assets to Total Capital (multiples) Bank Claims on Public Sector

70 11 23

133 16 7

51 14 18

33 8 7

128 11 ...

16 9 18

51 11 ...

47 9 –9

114 12 ...

67 13 –1

117 9 18

54 9 ...

Sources: Bank for International Settlements; CEIC; Economist Intelligence Unit; IMF, Financial Soundness Statistics, International Financial Statistics database, World Economic Outlook database; national authorities; and IMF staff calculations. 1BIS series on “credit to nonfinancial private sector” includes domestic and cross-border bank credit (loans and debt securities).

Table 1.5. Change in Gross Debt Levels in Selected Emerging Market Economies (Change since end-2008 through end-2013 or latest available; percentage points of GDP) Government Household Bank Credit to Nonfinancial Firms Banking Sector Credit

Brazil

China

India

Indonesia

Malaysia

Mexico

Poland

Russia

Singapore

South Africa

Thailand

Turkey

2.9 8.2 7.2 22.8

5.4 13.6 42.0 28.8

–7.8 –1.8 2.8 0.5

–7.1 4.2 2.3 5.7

16.9 20.1 ... 20.9

3.6 0.8 1.4 1.1

10.4 5.0 2.3 3.6

5.5 3.6 3.4 5.4

7.4 6.6 1.5 18.3

18.0 –5.4 –3.2 –12.7

8.0 24.1 1.1 20.6

–4.1 7.1 11.4 24.2

Sources: Bank for International Settlements; CEIC; IMF, World Economic Outlook database; national authorities; and IMF staff calculations. Note: Change in nonfinancial bank credit for South Africa is since June 2009.

Higher debt loads and lower debt-servicing capacity render the corporate sector more sensitive to tighter external financing conditions and to a reversal of capital flows that could precipitate a rise in borrowing costs and fall in earnings. A sensitivity analysis of a sample of large and small companies in selected emerging market economies suggests that a combination of a 25 percent increase in borrowing costs and a 25 percent decline in earnings could lead to an increase in the number of weak firms and their debt levels. Debt at risk—which is the amount of debt of firms with less than two times interest coverage after the shocks—appears high in a number of countries (Figure 1.20, panel 6). The share of weak firms after the shocks is highest in Argentina, Turkey, India, and Brazil, where they could account for more than half of all firms (Figure 1.20, panel 7).14 Within the sample of 15 countries, the debt at risk of weak firms that are highly leveraged could increase by $740 billion, rising to 35 percent of total corporate debt.15 14These shocks are consistent with high-stress events experienced in emerging markets in the past 10 years. 15Highly leveraged weak firms are defined as those with net debtto-EBITDA above 3, and interest coverage below 2.

How exposed are firms in emerging market economies to exchange rate and foreign currency funding risks? External debt accounts for more than one-fourth of total corporate debt in a number of emerging market economies (Figure 1.20, panel 8), which means that firms in those countries may be susceptible to exchange rate and foreign currency funding risks. The sensitivity of such economies to foreign currency shocks is highest when the corporate sector mostly depends on portfolio flows for its external funding. Economies with a significant proportion of corporate external debt from affiliates and direct investment, such as Bulgaria, Hungary, and Poland, are less sensitive to exchange rate volatility. Currency depreciation in an environment of rising global uncertainties could lead to higher payments of principal and interest on foreign currency debts and thus to a further erosion of profitability. The impact of currency depreciation on firms depends on the size of buffers, comprising natural hedges from overseas revenues and financial hedges from currency hedging. To gauge the sensitivity of earnings to exchange rate changes, a 30 percent depreciation in the exchange rate



Figure 1.15. Private Sector Gross Debt and Credit in Selected Emerging Market Economies (Percent of GDP; normalized at 2008 = 100)

China India Indonesia

8

Latin America and EMEA Malaysia Singapore Thailand

Brazil Mexico Poland

4 CHN

1. Household Debt 200

6

RUS

Russia South Africa Turkey 200

150

2

150

100

COL TUR

100

ZAF

HUN

ROM

CHL

THA

POL IDN IND BRA MEX

–2

PHL 50 2005 06 07 08 09 10 11 12

2005 06 07 08 09 10 11 12

50

175

150

150

125

125

100

100

75

75 2005 06 07 08 09 10 11 12

3. Banking Sector Credit

140

180

120 100 90 80

60

60 2005 06 07 08 09 10 11 12

2005 06 07 08 09 10 11 12

30

Sources: Bank of International Settlements; CEIC; IMF World Economic Outlook database; national authorities; and IMF staff calculations. Note: Bank credit to corporations for South Africa was normalized at 2009 = 100 because of missing data in 2008. EMEA = Europe, the Middle East, and Africa.

26


–6

–4

–2

0

2

4

–6

Sources: Bloomberg L.P.; national authorities; and IMF, World Economic Outlook database. Note: Real rates are calculated as two-year nominal swap rates as of March 24, 2014 minus latest annual inflation data. The 2003–08 period refers to January 2003 (wherever real rates are available) through June 2008. BRA = Brazil; CHL = Chile; CHN = China; COL = Colombia; HUN = Hungary; IDN = Indonesia; IND = India; MEX = Mexico; MYS = Malaysia; PHL = Philippines; POL = Poland; ROM = Romania; RUS = Russia; THA = Thailand; TUR = Turkey; ZAF = South Africa.

50

150

120

–8

–4

Current account balance as a percent of GDP, 2014 forecast

2. Bank Credit to Corporations 175

50 2005 06 07 08 09 10 11 12

–10

0 MYS

Two-year rate relative to 2003–08

Asia

Figure 1.16. Current Account Balance and Real Rates Now and Before the Financial Crisis

is applied to aggregate corporate foreign currency debt levels.16 Where foreign currency liabilities are largely hedged through natural hedges, foreign exchange losses could amount to 20–30 percent of earnings in India, Indonesia, and Turkey (Figure 1.20, panel 9). If half of the remaining foreign currency liabilities are hedged through currency hedges, the residual foreign exchange losses would be reduced to 10–15 percent of earnings in these economies and lower still in other economies.17 The effectiveness of hedges should be carefully considered. In past episodes of turbulence, natural hedges fell short of expectations, as overseas revenues declined in tandem with depreciating currencies. Moreover, some currency hedges with “knock-out” 16As information on financial hedging is sparse, this sensitivity analysis assumes that at least 50 percent of these debts are hedged after netting out natural hedges. 17The April 2014 Regional Economic Outlook: Asia and Pacific also concluded that the corporate sector may be more vulnerable to interest rate and profitability shocks than the aggregate data would suggest as firms that are highly leveraged tend to have lower profitability, lower interest coverage ratios, and are less liquid.


Figure 1.18. Ratio of International Reserves to 2014 External Financing Requirements

Figure 1.17. Policy Space

(Market expectations of policy rate changes versus inflation gap)

(Multiples) 200

7

BRA

3.0

–50 3.5

Inflation 2014 forecast minus inflation target (percent) Sources: Bloomberg L.P.; IMF, World Economic Outlook database; and IMF staff calculations. Note: “What Is Priced In” is the market-implied (inferred from interest rate swaps) expectation for policy rate changes over the next 12 months as of March 24, 2014. BRA = Brazil; CHL = Chile; COL = Colombia; HUN = Hungary; IDN = Indonesia; MEX = Mexico; PHL = Philippines; POL = Poland; THA = Thailand; TUR = Turkey; ZAF = South Africa. For countries with inflation target bands, the center of the band is considered as the inflation target.

options may terminate at specific exchange rate levels that render them worthless if large depreciations were to occur. How are financial markets pricing these balance sheet risks? The pricing of corporate emerging market bond index (CEMBI) spreads reflects a view of vulnerabilities similar to those presented in Figure 1.20, panels 6 and 7. Corporate bond spreads remain elevated in Brazil, Indonesia, the Philippines, Russia, South Africa, and Turkey (as shown by the average CEMBI spread levels in Figure 1.20, panel 10). These economies are also vulnerable on the basis of interest coverage (measured either as debt at risk or firms at risk). Model-based estimates of corporate bond spreads suggest varying degrees of sensitivity to external and balance sheet shocks.18 Leveraged firms in China, 18The model for corporate bond spreads explains the countrylevel CEMBI spreads against the VIX equity volatility index and the following median balance metrics for all country firms in the S&P Capital IQ samples: interest coverage ratio (EBIT to interest expense), leverage (net debt to total common equity), working capital to total assets, retained earnings to total assets, and cash levels to

Turkey

2.5

Argentina

2.0

Romania

1.5

South Africa

1.0

Chile

0.5

Colombia

0

Indonesia

–0.5

1

India

–1.0

4

2

Poland

CHL

0

Mexico

TUR

Hungary

THA

POL

5

3

Brazil

50

Thailand

IDN

Malaysia

HUN COL

Russia

MEX

Additional coverage by Flexible Credit Line

Philippines

100 PHL

6

China

150

What is priced in one year (basis points)

ZAF

0

Sources: IMF International Financial Statistics database, and World Economic Outlook database. Note: External financing requirements = short-term total external debt plus short-term portion of medium- and long-term total external debt minus current account balance. Reserves are as of end-2013 or latest. Colombia, Mexico, and Poland renewed their Flexible Credit Lines for two years in June 2013, December 2012, and January 2013, respectively.

Hungary, and Russia are more vulnerable to balance sheet shocks than to external shocks (Figure 1.20, panel 10, where the balance sheet portion of the bar is larger than the VIX portion).19 But for firms in countries that also exhibit some macroeconomic or external financing vulnerabilities, such as Brazil, Indonesia, South Africa, and Turkey, the external shock may have a larger impact on spreads than a deterioration of balance sheet variables. Banks remain resilient to a rise in corporate stress Slower economic growth and increasing pressures in the corporate sector could lead to a rise in nonpertotal assets. The panel regression for the 17 countries in Figure 1.20, panel 10 is performed on log-transformed quarterly data starting in 2003 or the earliest possible date thereafter. 19The greater vulnerability of these countries to balance sheet shocks is indicated in the model results after a deterioration in balance sheet metrics by two standard deviations and a 10 percentage point increase in the VIX equity volatility index, which correspond to roughly the same order of magnitude of shocks in previous episodes of risk aversion.



Figure 1.19. Coverage of Current Account by Foreign Direct Investment (2014 forecast; percent of GDP)

6

Net foreign direct investment Current account Sum

4 2 0 –2 –4 –6

Philippines

China

Hungary

Malaysia

Russia

Chile

Thailand

Mexico

Romania

Colombia

India

Brazil

Indonesia

Poland

South Africa

Turkey

–8

Source: IMF, World Economic Outlook database.

forming loans, thereby straining banks’ balance sheets. Banks in most countries have reported healthy levels of Tier 1 regulatory capital, but in some cases lax recognition of doubtful assets and loan forbearance may mask the true extent of asset quality risk. In such cases, loan losses in a severe downturn could overwhelm what were thought to be adequate levels of balance sheet equity capital and loan loss buffers. Relative to regional peers, loan loss provisioning appears low in Hungary, India, Indonesia, Malaysia, and South Africa (Figure 1.21, panel 1), suggesting that any potential credit quality deterioration may need to be absorbed by equity capital. What losses could banks absorb before capital ratios fall below Basel III’s minimum requirements? Most countries are able to meet the Basel III minimum Tier 1 capital requirement of 6 percent. However, when capital conservation buffers are included, Hungary and India have the lowest loss-absorbing buffers, followed by Chile and Russia, although buffers in these last two countries meet Basel III requirements20 (Figure 1.21, panel 2).

20Regulatory risk-weights vary across countries with some imposing stricter weights that could result in larger risk-weighted assets (RWA).

28


Banks are also exposed to funding pressures, particularly when wholesale funding becomes challenging during periods of global turmoil. Currently, loan-to-deposit ratios are high, at 100 percent and above, particularly in Latin America and EMEA (Figure 1.21, panel 3). Another source of funding risk emanates from excessive reliance on externally supplied credit. The share of external funding as a percentage of total assets is high in EMEA, especially in Hungary, Romania, and Turkey (Figure 1.21, panel 4). Moreover, more than 20 percent of EMEA banks’ debts maturing this year are in foreign currency, four times the corresponding shares in Asia and Latin America (Figure 1.21, panel 5). The combination of high domestic leverage and increased exposure to short-term foreign debt raises the sensitivity of the banking sector to currency and interest rate shocks. Stresses in emerging market economies may affect advanced economies through a number of channels. Large banks in advanced economies have increased their exposure to emerging market economies over the past two decades (Figure 1.21, panel 6), making them susceptible to profit fluctuations and asset quality issues in those markets.21 Portfolio investment, as detailed earlier in this section, has also increased, and advanced economies’ equity markets appear to have become more directly influenced by equities in emerging economies, as seen in the emerging market turmoil of 2013–14. And, as detailed in Chapter 2 of the April 2014 World Economic Outlook, many firms in emerging market economies are now well integrated into global supply chains, increasing the potential for spillovers related to finance as well as to trade. Risks in China’s nonbank financial sector Nonbank institutions have become an important source of financing in China and this is a natural consequence of a reform process that has prioritized the diversification of a bank-dominated financial system. Estimates of the size of nonbank credit outstanding (excluding bonds) vary, reflecting difficulties in measurement, a lack of disclosure, and a large informal sector. Unofficial conservative estimates that cover only the formal sector range between 30–40 percent of GDP, a doubling since 2010. Nonbank credit has 21Asset quality spillovers to a parent bank may be more significant in the case of direct cross-border lending, but less so for subsidiarybased operations.

CHAPTER 1


Figure 1.20. Corporate Debt in Emerging Markets Easy access to bond markets and prolonged low interest rates enabled record net issuance of hard currency debt …

… precipitating the rise in corporate debt above GDP in several countries.

1. Net New Issuance of Emerging Market Bonds (billions of U.S. dollars) 350

Sovereign

300

2. Corporate Sector Debt, 2013 (percent of GDP)

120

Corporate

100

External debt Debt owed to domestic capital market Debt owed to domestic banks

250 200

80 60

150

09

10

11

12

13

14

China

08

Malaysia

2007

0

3. Net Debt-to-EBITDA Ratio, 2008 and 2012

China

2012

3.0 2.5 2.0

India

Romania Russia

1.5

Thailand Hong Kong SAR Brazil Turkey Indonesia Colombia Mexico Hungary Poland Philippines Argentina Peru

Bulgaria

Hungary

Thailand

Turkey

Poland

India

…while higher debt loads have led to growing interest expense despite low rates.

4.0 3.5

Brazil

Sources: Bloomberg L.P.; IMF, Quarterly External Debt Statistics database; Financial Soundness Indicators database; and IMF staff calculations. Note: External debt includes liabilities from affiliates, direct investments, and other sources.

Philippines

Slowing profitability is beginning to pressure firms’ capacity to service debt …

Mexico

Sources: Bond Radar; and Morgan Stanley. Note: The 2014 data are through March 24, 2014.

Argentina

0

Russia

20 South Africa

50 Peru

40

Indonesia

100

4. Annual Growth Rates of Interest Expense (percent year-over-year) 2012 Five-year average

Chile Malaysia

60 50 40 30 20 10 0

South Africa

1.0 1.0

1.5

2.0

2.5

3.0

–10

3.5

–20

23 21

5. Debts of Weak Firms, 2007–12 (percent of total debt of all firms) 2007 2008 2009 2010 2011 2012

19

Poland

Chile

South Africa

Russia

Mexico

China

Turkey

India

Philippines

Thailand

Indonesia

Colombia

Source: S&P Capital IQ. Note: The growth rates are based on average of sample firms across each country.

Malaysia

The share of total corporate debt held by weak firms is rising again…

Brazil

Source: S&P Capital IQ. Note: Based on median. EBITDA = earnings before interest, taxes, depreciation, and amortization.

Argentina

2008

–30

…while balance sheets have become more sensitive to shocks… 6. Distribution of Debt-at-Risk by Interest Coverage Ratio (percent of total debt)

17 15 13 11

60

9

30

7 5

20

50 40

Latin America Europe, Middle East, and Africa

2–3

1–2

1 and below

Turkey

Philippines

Brazil

South Africa

China

Indonesia

India

Argentina

Poland

Mexico

Colombia

Malaysia

Thailand

Source: S&P Capital IQ. Note: Weak firms refer to those with interest coverage below two times. Interest coverage is defined as EBITDA/Interest Expense. Asia = China, India, Indonesia, Malaysia, Philippines, Thailand; Latin America = Argentina, Brazil, Chile, Colombia, Mexico; and Europe, Middle East, and Africa = Poland, Russia, South Africa, Turkey. EBITDA = earnings before interest, taxes, depreciation, and amortization.

10 Chile

Asia

Russia

All emerging markets

0

After stress (share of debts of ICR